Real option pricing and bounds in incomplete markets

This article prices a real option and constructs narrow bounds around the value of real options embedded in capital budgeting decisions by applying the minimax deviations approach to real options in incomplete markets. While it is straightforward to obtain the unique value of a real option with hyperbolic absolute risk aversion (HARA) utility functions, the parameters of risk aversion are often subject to misspecification and raise concerns for practical uses. Recognizing that investors allow deviation from parameter values related to a benchmark pricing kernel, we derive narrow bounds on a real option price. Comparison with the approaches in the literature clarifies advantages of the minimax bounds: simple, consistent, and efficient.