An Arbitrage-Free Approach to Quasi-Option Value

Posted: 26 Jul 1998

See all articles by Jay S. Coggins

Jay S. Coggins

University of Minnesota - College of Agricultural, Food and Environmental Sciences - Department of Applied Economics

Cyrus A. Ramezani

California Polytechnic State University, San Luis Obispo

Abstract

In the presence of uncertainty and irreversibility, dynamic decision problems should not be solved using expected net present value analysis. The right to delay a decision can be valuable. We show that the value of this right equals Arrow and Fisher's [K. J. Arrow and A. C. Fisher, Environmental preservation, uncertainty, and irreversibility, Quart. J. Econom. 88, 312--319 (1974).] quasi-option value. In a discrete model we show how to derive quasi-option value using methods from finance. These methods yield the advantage that they permit avoidance of the common pitfall of improperly matching a riskless discount rate with a risky project. In our arbitrage-free model, use of the riskless rate is appropriate. Two main findings are presented. First, if the stochastic dynamic process underlying the problem is known, the Arrow and Fisher and Henry [C. Henry, Investment decisions under uncertainty: The "irreversibility effect," Amer. Econom. Rev. 64, 1006--1012 (1974).] result, that improper use of net present value too often leads to early development, is correct. Second, if the process is assessed incorrectly, their result can be incorrect in the sense that net present value methods may lead to the correct outcome while the dynamic rule does not.

JEL Classification: Q20, Q28

Suggested Citation

Coggins, Jay S. and Ramezani, Cyrus A., An Arbitrage-Free Approach to Quasi-Option Value. Available at SSRN: https://ssrn.com/abstract=101570

Jay S. Coggins (Contact Author)

University of Minnesota - College of Agricultural, Food and Environmental Sciences - Department of Applied Economics ( email )

1994 Buford Avenue
St. Paul, MN 55108
United States
612-625-6232 (Phone)
612-625-2729 (Fax)

Cyrus A. Ramezani

California Polytechnic State University, San Luis Obispo ( email )

School of Business
San Luis Obispo, CA 93407
United States

Do you have negative results from your research you’d like to share?

Paper statistics

Abstract Views
1,012
PlumX Metrics