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Real options with priced regime-switching risk

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Date
2013
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Abstract
We develop a model of regime-switching risk premia as well as regime-dependent factor risk premia to price real options. The model incorporates the observation that the underlying risky income streams of real options are subject to discrete shifts over time as well as random changes. The presence of discrete shifts is due to systematic and unsystematic risk associated with changes in business cycles or in economic policy regimes or events such as takeovers, major changes in business plans. We analyze the impact of regime-switching behavior on the valuation of projects and investment opportunities. We find that accounting for Markov switching risk results in a delay in the expected timing of the investment while the regime-specific factor risk premia make the possibility of a regime shift more pronounced.
Keywords
Regime-switching risk premia , Regime-dependent risk premia , Real options
Citation
Driffill, J., Kenc, T., & Martin Sola, M. (2013). Real options with priced regime-switching risk. International Journal of Theoretical and Applied Finance, 16 (5). https://doi.org/10.1142/S0219024913500283
Publisher
World Scientific Publishing Company

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