FAQ Number 5
Is Possible to Use Real Options for Incomplete Markets?
What Changes? What Are the Possible Ways?
Answer: Yes, is possible to use.
- For incomplete markets the risk-neutral probability (martingale
measure) is not unique;
- So, risk-neutral valuation is not rigourously correct here because
there is a lack of market values;
- Academicians and practitioners use some ways to estimate the real
option value with incomplete markets.
In case of incomplete market, the alternatives for real options
- Assume that the market is approximately
complete (your estimative of market value is reliable) and
use risk-neutral valuation (with risk-neutral probability);
- Assume firms are risk-neutral
and discount with risk-free interest rate (with real probability);
- Specify preferences (the utility function)
of single-agent or the equilibrium at detailed level (see Duffie's
This is used by finance academicians.
In practice is difficult, if not impossible, to specify the utility of
a corporation (managers, stockholders);
- Use the dynamic programming framework with
an exogenous discount rate
Used by economists from academy: Dixit & Pindyck, Lucas, etc.
Corporate discount rate express the corporate preferences? This is
difficult to answer but most of time the discount rate is the only
observable referential risk-preference in a corporation.
Go to the Next FAQ: 6) Is true that
mean-reversion always reduces the options premium? What is the effect of
jumps in the option premium?
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