A Range-Based Finite Difference Approach to Valuing Options in Markov Switching Regimes*

*This research was initiated when Andrea Vidozzi and Luca Vidozzi were graduate students at the College of Business and Management, Northeastern Illinois University, Chicago.

Abstract

Recognizing the inflexibility inherent in standard capital budgeting analysis, recent research has provided new insights using a real options framework. This paper uses the explicit finite difference approach to value real options. However, instead of assuming a constant return and volatility term, we assume that these variables are sensitive to changes in the economic environment. Accordingly, we adapt our approach to incorporate a Markov switching feature. Further, we recognize that some of the modeling assumptions can be violated in a practical application. Therefore, we recommend using range based estimates of the real option value, as opposed to a point estimate.

*This research was initiated when Andrea Vidozzi and Luca Vidozzi were graduate students at the College of Business and Management, Northeastern Illinois University, Chicago.

BIOGRAPHICAL SKETCH

NAUZER BALSARA obtained his Ph.D. from Columbia University in 1986. He is the corresponding author for this paper.

ANDREA VIDOZZI and LUCA VIDOZZI completed their graduate studies in finance at Northeastern Illinois University, Chicago, in Fall 2003. They are currently pursuing their doctoral studies in Applied Mathematics at the Illinois Institute of Technology, Chicago. They can be reached via email at [email protected]

Notes

*This research was initiated when Andrea Vidozzi and Luca Vidozzi were graduate students at the College of Business and Management, Northeastern Illinois University, Chicago.