Modifying Real Option Exercise Probability: Examples and Testable Hypotheses

Modifying Real Option Exercise Probability: Examples and Testable Hypotheses

• Associate Professor of Finance Sang Baum “Solomon” Kang

Abstract:

Using Quantile-Preserving Spreads (QPS) and Stochastic Dominance, this paper studies how modifying a real option’s characteristic affects the real option holding value and optimal exercise decision. We find that the direction of change in exercise probability and timing depends on the preserved quantile, strike price, time of underlying modification, and whether a modification is symmetric or not. We significantly generalize previously obtained results to an unspecified underlying process and a general call-like payoff function. Our propositions and corollaries apply to various real option and economic policy problems, including but not limited to climate finance, real estate, research and development, and government intervention. Specifically, the results are useful to determine a modification of a real option to increase or decrease its exercise probability and timing. The audience will learn the distinction between financial options and real options, our propositions for real-option exercise probability/timing, and the related examples. Some of these will offer guidance for policymakers and empirical analysts.

 

All Illinois Tech faculty, students, and staff are invited to attend.

The Friday Research Presentations series showcases ongoing academic research projects conducted by Stuart School of Business faculty and students, as well as guest presentations by Illinois Tech colleagues, business professionals, and faculty from other leading business schools.

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