A
asbes
Member
Hi
The binomial-type calculations for pricing options using risk-neutral probabilities is usually not that difficult, but I am not always sure I understand why we use it.
Take Q&A 6.8 for example (about a real option).
In my mind the cashflows in Route 2 can be described as:
* future CF with a PV of 14 in 1 years time if the project is successful, or
* abandon the project and sell the assets for 9 at the end of year 1 if the project is a failure.
Then the value of this route can be calculated in a similar way as route 1 by just using 14 and 9 rather than 15 and 8.
In such a simple situation I do not see how having the real option has any other value than the possible cashflow.
If the cashflows from route 2 upon failure were uncertain, say 6 or 10, rather than just 6 then we could not be sure that the option to abandon will be exercised upon failure and then the option should have value.
Please let me know where I went wrong.
Thanks!
The binomial-type calculations for pricing options using risk-neutral probabilities is usually not that difficult, but I am not always sure I understand why we use it.
Take Q&A 6.8 for example (about a real option).
In my mind the cashflows in Route 2 can be described as:
* future CF with a PV of 14 in 1 years time if the project is successful, or
* abandon the project and sell the assets for 9 at the end of year 1 if the project is a failure.
Then the value of this route can be calculated in a similar way as route 1 by just using 14 and 9 rather than 15 and 8.
In such a simple situation I do not see how having the real option has any other value than the possible cashflow.
If the cashflows from route 2 upon failure were uncertain, say 6 or 10, rather than just 6 then we could not be sure that the option to abandon will be exercised upon failure and then the option should have value.
Please let me know where I went wrong.
Thanks!