Binomial basis for linear information dynamics: real options, dividends and the valuation of equity

Abstract

AbstractAnalytical research has confirmed that real options give rise to the kind of nonlinearities observed in practice between equity prices and the figures appearing on corporate financial statements. We develop these real option values in terms of a quasi ‘supply‐side’ model of linear information dynamics based on simple discrete time binomial filtration processes. Our analysis shows that the linear models that pervade the empirical (and analytical) work of the area, will almost certainly suffer from an omitted variables problem. Parameter estimation will then be inconsistent and inefficient.