scholarly journals Quadrinomial trees with stochastic volatility to value real options

2021 ◽  
Vol ahead-of-print (ahead-of-print) ◽  
Author(s):  
Freddy H. Marin-Sanchez ◽  
Julian A. Pareja-Vasseur ◽  
Diego Manzur
Keyword(s):  
Real Options ◽  
Stochastic Volatility ◽  
Risk Premium ◽  
Real Option ◽  
Numerical Test ◽  
Real Data ◽  
Diffusion Type ◽  
Content Type ◽  
Market Risk Premium ◽  
Black Scholes

PurposeThe purpose of this article is to propose a detailed methodology to estimate, model and incorporate the non-constant volatility onto a numerical tree scheme, to evaluate a real option, using a quadrinomial multiplicative recombination.Design/methodology/approachThis article uses the multiplicative quadrinomial tree numerical method with non-constant volatility, based on stochastic differential equations of the GARCH-diffusion type to value real options when the volatility is stochastic.FindingsFindings showed that in the proposed method with volatility tends to zero, the multiplicative binomial traditional method is a particular case, and results are comparable between these methodologies, as well as to the exact solution offered by the Black–Scholes model.Originality/valueThe originality of this paper lies in try to model the implicit (conditional) market volatility to assess, based on that, a real option using a quadrinomial tree, including into this valuation the stochastic volatility of the underlying asset. The main contribution is the formal derivation of a risk-neutral valuation as well as the market risk premium associated with volatility, verifying this condition via numerical test on simulated and real data, showing that our proposal is consistent with Black and Scholes formula and multiplicative binomial trees method.

scholarly journals A real option approach for the valuation of switching output flexibility in residential property investment

2018 ◽  
Vol 23 (2) ◽  
pp. 133-151 ◽  
Author(s):  
Kwabena Mintah ◽  
David Higgins ◽  
Judith Callanan
Keyword(s):  
Real Options ◽  
Real Option ◽  
Economic Value ◽  
Management Tool ◽  
Residential Property ◽  
Option Valuation ◽  
Content Type ◽  
Real Option Analysis ◽  
Real Option Valuation ◽  
Mixed Use

Purpose Uncertainties in residential property investment performance require that real estate assets are designed in a flexible manner to respond to impacts of market dynamics. Though estimating the cost of flexibility is straightforward, assessing the economic value of flexibility is not. The purpose of this study is to explore the potential practical application of real option analysis to determine the economic value of a switching output flexibility embedded in a residential property investment in Australia. The study involves the exploration of an optimal strategy for investment in a residential development through real option analysis and valuation of a mixed use investment. Design/methodology/approach The real option valuation model developed by McDonald and Siegel (1986) is adopted for the evaluation because the switching output flexibility is likened to a perpetual American call option with dividend payout. Findings Through real option analysis, the economic value of switching output flexibility of the mixed use building was determined to be higher than the initial upfront costs. Moreover, a payoff of about $4million was determined to be the value of the switching output flexibility, therefore justifying upfront investments in flexibility as an uncertainty and risk management tool. Practical implications This application is an important demonstration of the practical use of options pricing techniques (real options analysis) and delivers further evidence needed to support the adoption of real option valuation in practice. Flexibility can also enhance risks and uncertainty management in residential property investment better than the adjustment of discount rates. Originality/value There is limited evidence on the use of real options techniques for the valuation of switching output flexibility in practice, and this comes as an original application; both the case study and data are all initial applications of switching flexibility in the Australian property market.

The asymmetric impact of rational and irrational components of fear index on S&P 500 index returns

2017 ◽  
Vol 9 (3) ◽  
pp. 278-291 ◽  
Author(s):  
Gökçe Soydemir ◽  
Rahul Verma ◽  
Andrew Wagner
Keyword(s):  
Risk Factors ◽  
Risk Premium ◽  
Var Model ◽  
Impulse Responses ◽  
Market Returns ◽  
Stock Market Returns ◽  
Content Type ◽  
Market Risk Premium ◽  
Economic Fundamentals ◽  
The Impact

Purpose Investors’ fear can be rational, emanating from the natural dynamics of economic fundamentals, or it can be quasi rational and not attributable to any known risk factors. Using VIX from Chicago Board Options Exchange as a proxy for investors’ fear, the purpose of this paper is to consider the following research questions: to what extent does noise play a role in the formation of investors’ fear? To what extent is the impact of fear on S&P 500 index returns driven by rational reactions to new information vs fear induced by noise in stock market returns? To what extent do S&P 500 index returns display asymmetric behavior in response to investor’s rational and quasi rational fear? Design/methodology/approach In a two-step process, the authors first decompose investors’ fear into its rational and irrational components by generating two additional variables representing fear induced by rational expectations and fear due to noise. The authors then estimate a three-vector autoregression (VAR) model to examine their relative impact on S&P 500 returns. Findings Impulse responses generated from a 13-variable VAR model show that investors’ fear is driven by risk factors to some extent, and this extent is well captured by the Fama and French three-factor and the Carhart four-factor models. Specifically, investors’ fear is negatively related to the market risk premium, negatively related to the premium between value and growth stocks, and positively related to momentum. The magnitude and duration of the impact of the market risk premium is almost twice that of the impact of the premium on value stocks and the momentum of investors’ fear. However, almost 90 percent of the movement in investors’ fear is not attributable to the 12 risk factors chosen in this study and thus may be largely irrational in nature. The impulse responses suggest that both rational and irrational fear have significant negative effects on market returns. Moreover, the effects are asymmetric on S&P 500 index returns wherein irrational upturns in fear have a greater impact than downturns. In addition, the component of investors’ fear driven by irrationality or noise has more than twice the impact on market returns in terms of magnitude and duration than the impact of the rational component of investors’ fear. Originality/value The results are consistent with the view that one of the most important drivers of stock market returns is irrational fear that is not rooted in economic fundamentals.

Performance of Black-Scholes model with TSRV estimates

2015 ◽  
Vol 41 (8) ◽  
pp. 857-870 ◽  
Author(s):  
Shivam Singh ◽  
Vipul .
Keyword(s):  
Risk Premium ◽  
Market Prices ◽  
Volatility Risk ◽  
Content Type ◽  
Forecasting Error ◽  
Ex Post ◽  
Tick Data ◽  
Black Scholes ◽  
Realised Volatility ◽  
S Model

Purpose – The purpose of this paper is to test the pricing performance of Black-Scholes (B-S) model, with the volatility of the underlying estimated with the two-scale realised volatility measure (TSRV) proposed by Zhang et al. (2005). Design/methodology/approach – The ex post TSRV is used as the volatility estimator to ensure efficient volatility estimation, without forecasting error. The B-S option prices, thus obtained, are compared with the market prices using four performance measures, for the options on NIFTY index, and three of its constituent stocks. The tick-by-tick data are used in this study for price comparisons. Findings – The B-S model shows significantly negative pricing bias for all the options, which is dependent on the moneyness of the option and the volatility of the underlying. Research limitations/implications – The negative pricing bias of B-S model, despite the use of the more efficient TSRV estimate, and post facto volatility values, confirms its inadequacy. It also points towards the possible existence of volatility risk premium in the Indian options market. Originality/value – The use of tick-by-tick data obviates the nonsynchronous error. TSRV, used for estimating the volatility, is a significantly improved estimate (in terms of efficiency and bias), as compared to the estimates based on closing data. The use of ex post realised volatility ensures that the forecasting error does not vitiate the test results. The sample is selected to be large and varied to ensure the robustness of the results.

Political uncertainty and the US market risk premium

2020 ◽  
Vol ahead-of-print (ahead-of-print) ◽  
Author(s):  
Richard P. Gregory
Keyword(s):  
Risk Premium ◽  
Design Methodology ◽  
Market Risk ◽  
The Other ◽  
Political Uncertainty ◽  
Delayed Effect ◽  
Content Type ◽  
Market Risk Premium ◽  
The Us ◽  
Negative Effect

PurposeThe purpose of this study is to examine the bi-directional causality between political uncertainty and the market risk premium in the US.Design/methodology/approachI use a theoretical model to motivate signs and then check signs based on a vector autoregression.FindingsI find that political uncertainty has a small positive, delayed effect on the market risk premium. The market risk premium, on the other hand, has a large permanent, negative effect on political uncertainty.Originality/valueThis is the first research paper to consider the bi-directional effects of political uncertainty on the market risk premium and vice versa. It also finds interesting empirical results.

An empirical exploration of the performance of alternative option pricing models

2019 ◽  
Vol 11 (1) ◽  
pp. 23-49
Author(s):  
Aparna Prasad Bhat
Keyword(s):  
Option Pricing ◽  
Stochastic Volatility ◽  
Emerging Market ◽  
Pricing Models ◽  
Content Type ◽  
Black Scholes ◽  
Out Of Sample ◽  
Hedging Performance ◽  
Practical Implications ◽  
Skewness And Kurtosis

PurposeThe purpose of this paper is to ascertain the effectiveness of major deterministic and stochastic volatility-based option pricing models in pricing and hedging exchange-traded dollar–rupee options over a five-year period since the launch of these options in India.Design/methodology/approachThe paper examines the pricing and hedging performance of five different models, namely, the Black–Scholes–Merton model (BSM), skewness- and kurtosis-adjusted BSM, NGARCH model of Duan, Heston’s stochastic volatility model and anad hocBlack–Scholes (AHBS) model. Risk-neutral structural parameters are extracted by calibrating each model to the prices of traded dollar–rupee call options. These parameters are used to generate out-of-sample model option prices and to construct a delta-neutral hedge for a short option position. Out-of-sample pricing errors and hedging errors are compared to identify the best-performing model. Robustness is tested by comparing the performance of all models separately over turbulent and tranquil periods.FindingsThe study finds that relatively simpler models fare better than more mathematically complex models in pricing and hedging dollar–rupee options during the sample period. This superior performance is observed to persist even when comparisons are made separately over volatile periods and tranquil periods. However the more sophisticated models reveal a lower moneyness-maturity bias as compared to the BSM model.Practical implicationsThe study concludes that incorporation of skewness and kurtosis in the BSM model as well as the practitioners’ approach of using a moneyness-maturity-based volatility within the BSM model (AHBS model) results in better pricing and hedging effectiveness for dollar–rupee options. This conclusion has strong practical implications for market practitioners, hedgers and regulators in the light of increased volatility in the dollar–rupee pair.Originality/valueExisting literature on this topic has largely centered around either US equity index options or options on major liquid currencies. While many studies have solely focused on the pricing performance of option pricing models, this paper examines both the pricing and hedging performance of competing models in the context of Indian currency options. Robustness of findings is tested by comparing model performance across periods of stress and tranquility. To the best of the author’s knowledge, this paper is one of the first comprehensive studies to focus on an emerging market currency pair such as the dollar–rupee.

The effect of leverage on the performance of real estate companies

2018 ◽  
Vol 11 (3) ◽  
pp. 284-318 ◽  
Author(s):  
Giacomo Morri ◽  
Karoline Jostov
Keyword(s):  
Real Estate ◽  
Risk Premium ◽  
Market Risk ◽  
Local Market ◽  
Cross Sectional ◽  
Content Type ◽  
Crisis Period ◽  
Market Risk Premium ◽  
Fama And French ◽  
The Impact

Purpose This paper aims to investigate the impact of leverage on the total shareholder return of European publicly traded real estate vehicles in three periods: Crisis Period (2007-2009), Rebound Period (2009-2014) and the Whole Period. Design/methodology/approach Cross-sectional analysis is used and the leverage effect on the performance is controlled for seven other independent variables (local market risk premium, size, book-to-market, short-term debt, cash); moreover, regional differences are accounted for. Findings It is established that during the Crisis Period, leverage levels are negatively associated with performance: this relationship also holds throughout the Whole Period, implying that for real estate securities, the cost of financial distress is larger than the potential gain from taxation, although the economic significance of it is limited. The Fama and French (1992) three factors, including size, book-to-market and local market risk premium, are found to be relevant, which is consistent with the literature. In addition, the UK and Sweden regions are identified as significant. Originality/value Even if there is sizeable body of literature on determinants of leverage and determinants of asset returns, little work has been done on how leverage affects the returns of European real estate companies. In addition, this paper takes advantage of observations from a full economic cycle and the possible effects of the crisis period.

scholarly journals Staging option application to residential development: real options approach

2018 ◽  
Vol 11 (1) ◽  
pp. 101-116 ◽  
Author(s):  
Kwabena Mintah ◽  
David Higgins ◽  
Judith Callanan ◽  
Ron Wakefield
Keyword(s):  
Real Options ◽  
Real Option ◽  
Scenario Planning ◽  
Residential Development ◽  
Development Project ◽  
Option Valuation ◽  
Content Type ◽  
Real Option Valuation ◽  
Feasibility Evaluation ◽  
Fuzzy Payoff

Purpose Real option valuation is capable of accounting for uncertainties in residential development projects but still lacks practical adoption due to limited evidence to support application of the theory in practice. The purpose of this paper is to use option valuation to value staging option embedded in residential projects and compare with results from DCF to determine which of the two methods delivers superior results. Design/methodology/approach The fuzzy payoff method (FPOM), a real options model that uses scenario planning approach to generate a range of figures, from which a single-numerical value is computed for decision-making. Findings The results showed that the use of a range of figures was able to represent uncertainties to a higher degree of accuracy than the static DCF. As a result, the FPOM was able to capture about 3 per cent of the value of the project that was missed by the DCF. The staging option offers an opportunity to abandon unprofitable phases of a project, thereby limiting downside losses. Thus, real option models are practically applicable to cases in property sector. Practical implications Residential property developers must consider flexibility in financial feasibility evaluation of development because of the embedded value in uncertain property projects. It is important to account for optionality in financial evaluation of property projects for value maximisation. Originality/value The FPOM has been used for the first time to evaluate a horizontal phasing of a residential development project.

scholarly journals Managing risk using real options in company’s valuation

2014 ◽  
pp. 125-132
Author(s):  
Edina Kulcsár
Keyword(s):  
Risk Management ◽  
Real Options ◽  
Real Option ◽  
Capital Budgeting ◽  
Total Risk ◽  
Strategic Decisions ◽  
The Real ◽  
Black Scholes Model ◽  
Black Scholes

The valuation of company is very important because provides information about the current value/situation of company, and through this, provide the opportunity of choosing the best company’s growth alternatives. The future strategic decisions are characterized by lack of knowledge, information, so all measures of company’s growth are closely linked with uncertainty and risk. The company’s valuation process is also related with uncertainty and risk. The risk may result both from the assessed assets and the technique used. In literature, we could find three approaches for risk management: capital budgeting based method, methods based on portfolio analysis and real options approach of risk management. Among them, the real options based methods is the most revolutionary approach for risk management. The advantages of the method, consists in the fact, that the process of establishing strategic decisions integrates the possibility of reversibility, delay and rejections, which isn’t it possible at two previous methods. The method also takes into account the total risk of company, so both the company-specific and systematic risk. In this study, I have used one of the best-known real option based method, the Black-Scholes model, for determining the option’s value. Determination of option value is based on the data of enterprise, which was tested Monte Carlo simulation. One of the basic assumptions of the Black-Scholes model is that the value of option is influenced by several factors. The sensitivity of option’s value could be carried out with so-called “Greeks”.. In the study the sensitivity analysis, was carried out with indicators Delta (Δ), Gamma (Γ) and Vega (ν). The real options based risk management determinations were performed in the R-statistics software system, and the used modules are 'fPortofio' and 'mc2d'. By using of real options method, I have calculated the average value of company capital equal with 38.79 million. By using simulation was carried out 1000 runs. The results of this show a relatively low standard deviation, small interquartile range and normal distribution. In the calculation of indicator Delta, could be concluded the value of company moves in 0.831 proportion to the price of options, the standard deviations of index is low, so the real option based method could be used with success in company’s value estimation. The Gamma index shows the enterprise value is sensitive just for large changes. The result of Vega reflects the value of option, so the company’s value volatility, which is small in this case, but this means a volatility of value. In summary, we can conclude that the call options pricing model, well suited for the determination of company’s value.

scholarly journals Real Option Valuation with Stochastic Interest Rate and Stochastic Volatility

Matematika ◽  
2019 ◽  
Vol 18 (2) ◽  
Author(s):  
Ramdhan Fazrianto Suwarman
Keyword(s):  
Interest Rate ◽  
Real Options ◽  
Stochastic Volatility ◽  
North Sea ◽  
Real Option ◽  
Oil Field ◽  
Stochastic Interest Rate ◽  
Option Valuation ◽  
Real Option Valuation ◽  
Stochastic Interest

Abstract. Real options are one of the most interesting research topics in Finance since 1977 Stewart C. Myers from MIT Sloan School of Management published his pioneering article on this subject in the Journal of Financial Economics. Real options are techniques for supporting capital budgeting decisions that adapt techniques developed for financial securities options. The purpose of using this real option is to capture the options contained in projects that cannot be captured by the discounted cash flow model which operates as a basic framework for almost all financial analyzes. The process of valuing real options will be complemented by the stochastic interest rate and stochastic volatility to better capture the flexibility and volatility of the existing economic and financial situation. The valuation will use a Monte Carlo simulation with the MATLAB programming language on crude oil data from the North Sea oil field. Data were obtained from the thesis of Charlie Grafström and Leo Lundquist with the title "Real Option Valuation vs. DCF Evaluation – An Application to a North Sea oilfield".Keyword: real options, stochastic interest rate model, stochastic volatility model, simulation

Valuing green building certificates as real options

2014 ◽  
Vol 7 (2) ◽  
pp. 181-198 ◽  
Author(s):  
Jussi Vimpari ◽  
Seppo Junnila
Keyword(s):  
Real Options ◽  
Real Option ◽  
Green Building ◽  
Green Buildings ◽  
Content Type ◽  
Real Option Valuation ◽  
Pricing Theory ◽  
Option Pricing Theory ◽  
Industry Professionals ◽  
Real Option Value

Purpose – The purpose of this study is first to evaluate whether real options analysis (ROA) is suitable for valuing green building certificates, and second to calculate the real option value of a green certificate in a typical office building setting. Green buildings are demonstrated as one of the most profitable climate mitigation actions. However, no consensus exists among industry professionals about how green buildings and specifically green building certificates should be valued. Design/methodology/approach – The research design of the study involves a theoretical part and an empirical part. In the theoretical part, option characteristics of green building certificates are identified and a contemporary real option valuation method is proposed for application. In the empirical part, the application is demonstrated in an embedded multiple case study design. Two different building cases (with and without green certificate) with eight independent cash flow valuations by eight industry professionals are used as data set for eight valuation case studies and analyses. Additionally, cross-case analysis is executed for strengthening the analysis. Findings – The paper finds that green certificates have several characteristics similar to real options and supports the idea of using ROA in valuing a green certificate. The paper also explains how option pricing theory and discounted cash flow (DCF) method deal with uncertainty and what shortcomings of DCF could be overcome by ROA. The results show that a mean real option value of 985,000 (or 8.8 per cent premium to the mean property value) was found for a Leadership in Energy and Environmental Design Platinum certificate in the Finnish property market. The main finding of the paper suggests that the contemporary real option valuation methods are appropriate to assess the monetary value and the uncertainty of a green building certificate. Originality/value – This is the first study to argue that option-pricing theory can be used for valuing green building certificates. The identification of the option characteristics of green building certificates and demonstration of the ROA in an empirical case makes questions whether the current mainstream investment analysis approaches are the most suitable methods for valuing green building certificates.

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