Chapter 6 - Student's distribution and the value of real options

Abstract

This chapter presents a closed-form solution for the value of the option to invest in a capital project when the option to do so has a finite life. In doing so, it is assumed that the capital project's net present value evolves in terms of the student distributions that exhibit the fat tail properties characterizing at least some of the empirical distributions of research and development. However, most analytical work conducted in this area assumes that the option to undertake an investment project has an infinite life. Unfortunately, many real-life investment opportunities are not infinitely lived but expire and become worthless at a known point in time. This analysis provides an explicit closed-form solution for the valuation of finite-lived derivative securities of this kind. Closed-form solutions are however, notoriously difficult to come by. Yet, despite the difficulties associated with obtaining closed-form solutions, there is one variation to the analysis that is worthy of further investigation. This stems from the fact that many asset prices appear to evolve in terms of distributions that exhibit not only fat tails but also significant skewness.