risk-neutral measure

[asbes]

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!

 

[Colin McKee]

risk neutral

Hi
I am not an expert on these I must say. There is a further reading reference to Brealey and Meyers where various examples of these can be found. They are calculated in a similar way to the examples we have devised on the notes. Also there is an actuarial example which popped up in the Actuarial CPFE paper April 2005, Q8. It was the appearance of this question that made me worry that it might pop up in SA5. However, most SA5 questions to date seem to be asking for discussion and analysis rather than calculation of real options.
My understanding is that the option changes the riskiness of the project. So you cant simply say that value is 0.5(14 + 9)/1.1, because the risk is reduced and hence the 1.1 discount factor no longer applies. We have to calculate the project value as 0.5(14+6)/1.1 and then add the option value separately. Not sure though. Hope this helps.
Colin