Real Option Valuation: Dynamic Programming of Mean Reverting Binomial Lattice

Abstract

The binomial real options valuation approach using the market asset disclaimer assumption with an emphasis on state-dependent cash flows is reviewed and implemented using geometric Brownian Motion as the stochastic process for project uncertainty and the cash flows. A comprehensive analysis is conducted to identify the value drivers of options, including timing-aspects, intrinsic option value versus the value of flexibility, sensitivities of the binomial model to interest rate and volatility, and revision of volatility estimates for the BDH case. The example case is then extended by using the mean reverting stochastic process for the project value and cash flows using the censored binomial presented by Hahn (2005) and the non-censored binomial presented by Bastian-Pinto, Brandão, and Hahn (2010). Finally, the case is valued with a simple, European option equivalent, Monte Carlo approach with the underlying factors following geometric Brownian Motion and mean reverting models, and the results are compared.