Real option projects with correlated uncertainties
Abstract
Contingent claims are traditionally priced through the use of replicating portfolios, or risk neutral valuation. When markets are incomplete, as it occurs with many projects and is often the case with claims on real assets when firms are subject to private, project specific risks, these risks cannot be hedged and a replicating portfolio cannot be built. This paper proposes a modified approach that enhances the methodology originally developed by Copeland and Antikarov (2001) which provides a practical method to evaluate projects where management flexibility and correlated risks are present, using the concept of partially complete markets by Smith and Nau (1995).
Key words: real options, correlated uncertainties, private risks.
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