Abstract

AbstractThis paper modifies the standard binomial option pricing approach to real options analysis so that it can incorporate learning options. These options allow a manager to gather information about a potential investment payoff prior to investment occurring. The project's overall volatility will vary in the run‐up to investment, being higher when the manager gathers more information about the eventual investment payoff. This paper shows how to construct a recombining tree for the project's anticipated value by making the time steps shorter during periods of high volatility. It describes a simple scheme for calculating the lengths of these steps and the risk‐neutral probabilities that are needed to calculate arbitrage‐free asset prices. Copyright © 2011 Wilmott Magazine Ltd.

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