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Mathematical Finance

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New submissions for Fri, 16 Mar 18

[1]  arXiv:1803.05831 [pdf, other]
Title: Technical Uncertainty in Real Options with Learning
Comments: Originally posted Oct 6 2014 on SSRN at this http URL
Subjects: Mathematical Finance (q-fin.MF)

We introduce a new approach to incorporate uncertainty into the decision to invest in a commodity reserve. The investment is an irreversible one-off capital expenditure, after which the investor receives a stream of cashflow from extracting the commodity and selling it on the spot market. The investor is exposed to price uncertainty and uncertainty in the amount of available resources in the reserves (i.e. technical uncertainty). She does, however, learn about the reserve levels through time, which is a key determinant in the decision to invest. To model the reserve level uncertainty and how she learns about the estimates of the commodity in the reserve, we adopt a continuous-time Markov chain model to value the option to invest in the reserve and investigate the value that learning has prior to investment.

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