Real options - realistic valuation

Abstract

In valuation of real options, a widely accepted assumption is that the underlying real asset is perfectly correlated with a financial one. As a result, valuation techniques from the financial world can be used. Since this assumption is in general unrealistic and may lead to substantial mispricing, even if the correlation is very high but not perfect, we argue that a different approach is more adequate. It is based on a simple principle of invariance of the market price of risk computed for certain portfolios involving the underlying asset and the options. This is illustrated on a simple model where we can clearly see the relations between the prices obtained by various methods.