A Range-Based Finite Difference Approach to Valuing Options in Markov Switching Regimes*

Abstract

Recognizing the inflexibility inherent in standard capital budgeting analysis, recent research has provided new insights using a real options framework. This paper uses the explicit finite difference approach to value real options. However, instead of assuming a constant return and volatility term, we assume that these variables are sensitive to changes in the economic environment. Accordingly, we adapt our approach to incorporate a Markov switching feature. Further, we recognize that some of the modeling assumptions can be violated in a practical application. Therefore, we recommend using range based estimates of the real option value, as opposed to a point estimate. *This research was initiated when Andrea Vidozzi and Luca Vidozzi were graduate students at the College of Business and Management, Northeastern Illinois University, Chicago.