Model Risk in Real Option Valuation

Abstract

We introduce a general decision tree framework to value an option to invest/divest in a project, focusing on the model risk inherent in the assumptions made by standard real option valuation methods. We examine how real option values depend on the dynamics of project value and investment costs, the frequency of exercise opportunities, the size of the project relative to initial wealth, the investor's risk tolerance (and how it changes with wealth) and several other choices about model structure. For instance, contrary to stylized facts from previous literature, real option values can actually decrease with the volatility of the underlying project value and increase with investment costs.