Real Options Valuation: The Importance of Interest Rate Modelling in Theory and Practice (Lecture Notes in Economics and Mathematical Systems)

This book analyzes real options valuation for non-constant versus constant interest rates using simulation and historical backtesting. Several real options are investigated and combined with various pricing tools and stochastic term structure models. Interest rates for real options valuation are simulated by using stochastic term structure models (Vasicek, Cox-Ingersoll-Ross, Ho-Lee, and Hull-White one-factor and two-factor models) and by using implied forward rates. The book shows that the assumption of a constant interest rate in real options valuation is not justifiable. All necessary theory is provided in the book. The analyses were conducted using a proprietary computer simulation program. All results are explained in detail and rules are derived for application in Corporate Finance practice. For the first time, a systematic analysis based on simulations and historical backtesting compares real options valuation using constant interest rates and the implied forward rates with methods that simulate interest rates stochastically. Managerial decision-making during the lifetime of a project can have im­ portant implications on project handling and its contribution to shareholder value. Traditional capital budgeting methods (in particular methods based on net present value) fail to capture the role of managerial degrees of free­ dom and therefore tend to lead to a systematic undervaluation of the project. In contrast, the real options approach to investment analysis characterizes decision-making flexibility in terms of (real) option rights which can be eval­ uated analogously to financial options using contingent-claims pricing tech­ niques widely used in capital markets. The research carried out by Marcus Schulmerich analyzes real options for n- constant and stochastic interest rates versus constant interest rates. Analyzing stochastic interest rates in the context of real options valuation is of particular relevance given their long time to maturity which makes them more vulnera­ ble to interest rate risk than short-term financial options. To date, there has not been a comprehensive review of this issue in the academic literature. The fact that interest rates have fiuctuated widely over the recent years further highlights the need for studying this issue. 1. Introduction -- 2. Real Options In Theory And Practice -- 3. Stochastic Models For The Term Structure Of Interest Rates -- 4. Real Options Valuation Tools In Corporate Finance -- 5. Analysis Of Various Real Options In Simulations And Backtesting -- 6. Summary And Outlook. Marcus Schulmerich. Originally Presented As The Author's Doctoral Thesis To The European Business School, Oestrich-winkel. Includes Bibliographical Reference (pages 345-353) And Index. Introduction....Pages 1-17 Real Options in Theory and Practice....Pages 19-67 Stochastic Models for the Term Structure of Interest Rates....Pages 69-129 Real Options Valuation Tools in Corporate Finance....Pages 131-190 Analysis of Various Real Options in Simulations and Backtesting....Pages 191-330 Summary and Outlook....Pages 331-342