Valuing Real Options in Incomplete Markets

In this paper, we develop a framework for valuing real options and portfolios of real options in incomplete markets and show that it is a consistent generalization of contingent claims analysis, which is conventionally used for real option valuation in complete markets. The development of a framework for incomplete markets is motivated by the difficulty to construct replicating portfolios in practice, especially for projects that lead to innovative new products, which seldom share similarities with existing market-traded assets. The framework relies on (i) a decision-tree-based mixed asset portfolio selection model, which is able to capture managerial flexibility and relevant opportunity costs, and (ii) the concepts of opportunity buying and selling prices, which are extended from the notions of breakeven buying and selling prices. The use of a portfolio model is necessary, because in incomplete markets the value of a real option depends on the investor’s preference model, the available budget, and on other assets in the portfolio, including the real options they contain. We demonstrate the use of the model through a series of numerical experiments and compare the results to Capital Asset Pricing Model prices and Black-Scholes values.