Multiple volatility real options approach to investment decisions under uncertainty

Document Type

Journal Article

Publication Title

Decision Analysis

Volume

19

Issue

2

First Page

79

Last Page

98

Publisher

INFORMS

School

School of Business and Law

RAS ID

43960

Comments

Chandra, A., Hartley, P. R., & Nair, G. (2022). Multiple volatility real options approach to investment decisions under uncertainty. Decision Analysis, 19(2), 79-187. https://doi.org/10.1287/DECA.2021.0449

Abstract

We present a novel multiple volatility real options approach (MVR) to value investment projects with embedded flexibility and affected by multiple uncertainties. A core innovation is the MVR decision tree composed of MVR synthetic tree components, each reflecting a unique binomial process that approximates a geometric Brownian motion of project value induced by one uncertainty source. MVR uses Monte Carlo simulation to generate volatility of project value log-returns arising from each uncertainty source. MVR produces a multidimensional surface, which is hidden in other approaches, representing enhanced net present value (ENPV) as a function of each uncertainty. It allows the impact of each uncertainty’s volatility on ENPV to be measured through three MVR sensitivity analysis levers. To illustrate MVR, it is applied to a real-world investment project, revealing that MVR provides a more accurate valuation than alternative approaches that do not account for separate impacts of each uncertainty. MVR with its greater veracity, provides robust investment decisions through MVR decision rules.

DOI

10.1287/DECA.2021.0449

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