Learning Options and Binomial Trees

Abstract

This 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.

Keywords: real options, learning options, information gathering, binomial option pricing model

JEL Classification: G31, D81, C61