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Merton, Black & Scholes Model

The correct valuation of risky projects with options will manage to account for the constant variation in the level of risk as it changes through time. This is based on the statistical measurement of historical risk associated with the underlying assets associated with the project, specifically on their performance in the market and their volatility compared to the overall market.

Although it is assumed that options analysis can be applied in almost all circumstances, this does not seem practical. The standard financial tools for valuing real options are generally inadequate for many new risky projects and products, because the right data are not available. For example, Kodak recognized that its new products are unique and normally have no comparable antecedents; it therefore used decision analysis to estimate the value of flexibility.

In short, neither of the two obvious alternatives for valuing risky projects is really appropriate as a general method. Decision analysis cannot deal with the fact that the discount rate ought to reflect the changing levels of risk over time. Options analysis requires data that are rarely available for major technological systems, especially for innovations for which there cannot be a meaningful historical record. How should this dilemma be resolved?

Concept for Effective Valuation of Risky Projects

There are two different kind of risks associated with the project. One kind can be dealt with effectively and properly by decision analysis, the other through options analysis. The entire set of risks can then be evaluated realistically and accurately using the hybrid real options method.

The risks associated with the new project are: -

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* Contributed by -
Jyoti Singh,
PGDBM 2006,
IMT, Ghaziabad.