SIMPLE APPROACH FOR DECIDING: The Interest Rate Option 5

The constant certainty equivalent assumption is also a standard, if implicit, assumption in many applications in the real options literature. For example, in their analysis of the same option Ingersoll and Ross (1992) impose the far more restrictive assumption of riskless cash flows. Furthermore, the single period CAPM pricing relation is often used, in this […]

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SIMPLE APPROACH FOR DECIDING: The Interest Rate Option 4

In the general case with uncertain cash flows, the above proposition derives the optimal investment rule using certainty equivalents. The next proposition derives the appropriate discount rate if the simple NPV rule is used instead (i.e., the expected cash flows rather than their certainty equivalents are discounted). Let the risk adjusted discount rate (i.e., the […]

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SIMPLE APPROACH FOR DECIDING: The Interest Rate Option 3

Another example would be projects in which all cash flow uncertainty is idiosyncratic (cov (e(t), “(t)) = 0, Vt). In both cases the assumption is satisfied trivially because ж is always zero. A non-trivial example of a set of primitives that provides (1) with ж non-zero is if

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SIMPLE APPROACH FOR DECIDING: The Interest Rate Option 2

A General Rule The example demonstrates that by simply replacing the riskless rate with the mortgage rate, the simple NPV rule can be used to determine when to invest. Since mortgage interest rates are as easily observable as riskless rates themselves, this result has the potential to be as useful as the simple NPV rule […]

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SIMPLE APPROACH FOR DECIDING: The Interest Rate Option

Assume that each state is equally likely under the risk neutral probability measure, or equivalently, that the Arrow-Debreu state price of each pure state claim is the same. If r is the current risk free short rate and rc is the current risk free consol rate, then, under the risk neutral measure, the value today […]

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