1. Identifying Real Options

1.3. Do Valuation Models Work?

As we have seen in the previous section, standard option valuation models make a lot of rather restrictive assumptions. In particular, for investors to be able to build replicating portfolios:

  • The underlying asset needs to be traded
  • We need to be able to estimate the relevant option pricing parameters (in particular the volatility or the u and d factors)
  • There has to be an active market for the option itself
  • The cost of exercising the option must be known and clear today.

 

If the above conditions are violated (which they will almost always be in the real life), value estimates will be rather imprecise.