Perspectives in Science (2016) 7, 10—18

Available online at www.sciencedirect.com

ScienceDirect

journal homepage: www.elsevier.com/pisc

Real options valuation with changing

volatility夽
Miroslav Čulík

VSB — Technical University Ostrava, Faculty of Economics, Finance Department, Sokolska trida 33,
701 21 Ostrava, Czech Republic

Received 25 September 2015; accepted 11 November 2015

Available online 10 December 2015

JEL Summary This paper aims at the valuation of real options with changing volatility. Volatility
CLASSIFICATION change is a typical feature of real investment projects, where the riskiness of cash flow gener-
G11; ated by the project can change significantly during the project life span. In this paper, there is
G12; explained how the problem of changing volatility can be considered if binomial lattice and repli-
G13; cation strategy is used for real option valuation. There are recombining and non-recombining
G31 lattice used and constant and increasing volatility are analysed and results compared. In situ-
ation when volatility is changing, two approaches overcoming this problem are employed and
KEYWORDS
compared.
Real options;
© 2015 Published by Elsevier GmbH. This is an open access article under the CC BY-NC-ND license
Valuation;
(http://creativecommons.org/licenses/by-nc-nd/4.0/).
Risk-neutral;
Transition
probabilities;
Binomial lattice;
Recombining;
Non-recombining;
Volatility

Introduction Compared to the traditional passive valuation approaches

Real options methodology is a relatively new approach for
solution of a wide range of valuation and decision-making
issues. Here, traditional methods and models used for finan-
cial option valuation are used for real assets valuation.
夽 This article is part of a special issue entitled ‘‘Proceedings of
the 1st Czech-China Scientific Conference 2015’’.
E-mail address: Miroslav.culik@vsb.cz
(NPV, IRR, etc.), real option approach takes into consid-
eration two important aspects: (a) riskiness of cash flow
generated by the assets and (b) flexibility, i.e. capability
of management to change past decision or to make new
ones in already undertaken projects. These future possi-
ble decisions (depends on the future state of the world) are
modelled as a formal call and put options, which have their
value and can be exercised by company’s management. Real
asset value provided by the real option methodology appli-
cation is given as a sum of two components: present value of

http://dx.doi.org/10.1016/j.pisc.2015.11.004
2213-0209/© 2015 Published by Elsevier GmbH. This is an open access article under the CC BY-NC-ND license
(http://creativecommons.org/licenses/by-nc-nd/4.0/).
Real options valuation with changing volatility
directly measurable cash flows and flexibility value, which
captures managerial possibilities (real options).
As mentioned, assets value and future managerial oppor-
tunities captured in real options are quantified by financial
option valuation models. These models are based on some
assumptions, which are sometimes difficult to keep due to
the specific feature of real investments and real options
captured in them (constant volatility, risk free rate, etc.).
That is why it is necessary to adjust these models to spe-
cific conditions of a given project otherwise these are not
applicable.
Expanded NPV = standard (static, passive) NPV of directly measurable cash flows
+ flexibility value (value of real options from active management).
The goal of this paper is the application of financial option
valuation models on the real asset under specific condition
typical for most real investments — changing risk (cash flow
volatility) during the expected life span.
The paper is structured as follows. First, real option
methodology is described and classification of financial
option valuation models and application possibilities is
stated. In the subsequent part, mathematical background
for lattice valuation models is provided including the situa-
tion of variable parameters. In the end, illustrative example
is stated.
Real options methodology and flexibility
valuation
Real options methodology represents an approach where
financial options pricing theory and models are applied on
real assets valuation.
There are many applications in corporate finance where
the financial option valuation models are applied on the real
assets valuation (real options approach). Black and Scholes
(1973) were the first authors to state that it is possible
to take the equity in a levered company as a call option
on the company value. Since then, new pioneering work
appeared developing real option analysis; see for example
Merton (1973), Cox et al., 1979 or Brennan and Schwartz
(1985). During the last two decades, significant increase in
publishing activities on this topic is obvious. This area has
been studied and developed by many authors, and new pos-
sible applications appear for solutions for a wide array of
financial-decision and valuation problems. The key papers
and books that focus on the real options methodology appli-
cation are those of Dixit and Pindyck (1994), Smith and
Nau (1995), Trigeorgis (1999), Brennan and Trigeorgis (2000),
Copeland and Antikarov (2003), Grenadier (2000), Brach
(2002), Trigeorgis and Schwartz (2001), Trigeorgis and Smith
(2004) or Damodaran (2006).
Real options methodology application on real projects is
justifiable only if:
I. There is risk.
II. Risk drives project value.
11
III. Management has flexibility.
IV. Flexibility strategies (real options) are creditable and
executable.
V. Management is rational in executing real options.
Future managerial investment opportunities captured in
real options and quantified by financial option valuation
models represent the flexibility component (active part) of
the project value. The total project’s NPV then consists
of two components: the traditional static (passive) NPV of
directly measurable expected cash flows, and the flexibil-
ity value capturing the value of real options under active
management, i.e.,
Valuation procedure by applying real options method-
ology when discrete valuation model is applied can be
described by the following steps:
1. Estimation of the type and parameters of the underlying
asset random evolution (return mean, standard deviation
of returns);
2. Simulation of the future random underlying asset evolu-
tion for each discrete node of the tree;
3. The option’s intrinsic value calculation (for given type of
real option or portfolio of options) for each discrete node
of the tree;
4. Flexibility and asset’s value quantification; and
5. Recommendation of the optimal decision.
For flexibility quantification, traditional models for finan-
cial options pricing are employed. These models can be
classified as follows: (a) analytical (Black—Scholes model),
discrete (binomial, trinomial, multinomial), and simulation
(Monte Carlo).
Because the real options are mostly the American options
(decisions can be made at any time until the investment
opportunity disappears), more possible decisions can exist
at a given point of time, so the discrete valuation model on
the basis of replication strategy is frequently applied.
Replication strategy for option valuation
This approach relies on the fact that it is possible to set
up a portfolio of the underlying asset and risk free borrow-
ing, whose value replicates the payoff of the option for any
state of the underlying asset value. Because there are two
assets (portfolio, option) providing identical payoffs, in the
absence of arbitrage opportunities, their current price must
be the same. This makes it possible to work out the cost of
setting up the portfolio and, thus, the option’s price.
The following symbols are used for the option’s price
derivation: h is the quantity (number of units) of the under-
lying asset, St is the price of the underlying asset at t, Bt is
the monetary amount of the risk free borrowings, Ct is the
option’s price at t, t is the value of the replication port-
folio, Rf is the risk free rate, and u (d) is the proportional
increase (or decrease) in the price of the underlying asset.
12 M. Čulík

The cost of setting up the replication portfolio consisting t t + dt t t + dt t t + dt

of h units of the underlying asset and risk free borrowings at
time t is:

= h · St + B t , (2.1)
t

and in the absence of arbitrage opportunities it must hold n

that the value of the replication portfolio and the option’s
price must be identical: Figure 1 Discrete stochastic lattices (left-binomial, middle-
 trinomial, right-multinomial).
Ct = = h · St + B t . (2.2)
t

If the underlying asset moves up at the time t + dt, it Real option valuation under changing volatility
holds for the portfolio value:
u There are a lot methods and approaches in finance theory,
u
Ct+dt = = h · St+dt
u
+ Bt · (1 + Rf )dt , (2.3) which are applicable for option pricing. These methods and
t+dt approaches range from analytical equations (Black—Scholes
and if it moves down: model), lattice models (binomial, trinomial, multinomial),
d simulation (Monte Carlo) to using partial-differential equa-
d
Ct+dt = = h · St+dt
d
+ Bt · (1 + Rf )dt . (2.4) tions (finite difference method).
t+dt
Generally, real options can be quantified by applying any
Under the assumption that the payoff of the European of these approaches. Due to specific features of real options
call option at maturity T is equal to its intrinsic value, discrete lattices are mostly employed. The reason is as fol-
that is CTu = IVTu = max(STu − X; 0) and CTd = IVTd = max(STd − lows:
X; 0); then, by solving the set of Eqs. (2.3) and (2.4) for
h and B and substituting this number into (2.2), we get for — easy calculation, interpretation,
the option’s price: — easily accommodate most types of real options problems,
  — valuation of both plain vanilla (call, put) and exotic
dt St · (1 + Rf )dt − St+dt
d
(Bermudian, Asian, etc.) options,
Ct · (1 + Rf ) = u
Ct+dt · u
St+dt − St+dt
d — managerial strategic decisions are made rather at dis-
  crete time moment than continuously,
u
St+dt − St · (1 + Rf )dt — valuation of multinomial real options (more possible deci-
+ Ct+dt
d
· , (2.5) sions are available at given time moment),
u
St+dt − St+dt
d
— valuation of real options with multiple sources of risk,
— valuation of real options with variable parameters
where (.) on the right-side of (2.5) represents the risk-
(changing volatility, exercise price, risk free rate, etc.).
neutral probabilities of up and down movements.
Formula (2.5) can be reduced to

Ct = [Ct+dt
u
· pu + Ct+dt
d
· (1 − pu )] · (1 + Rf )−dt . (2.6) Simulation via discrete lattice1

It is apparent from (2.6) that the European option’s price
at t is equal to its expected payoff at the subsequent period
t + dt discounted at the risk-free rate.
The procedure for the American options is similar to that
of the European options, i.e., we work back through the tree
from the end to the beginning, and, moreover, we are testing
at each node whether the early exercise is optimal. The
value of the American call option at maturity (end nodes of
the tree) is the same as for the European options; at earlier
nodes, the option’s price is greater than its expected payoff
at the subsequent period t + dt, discounted at the risk-free
rate or the payoff (intrinsic value) IVt from early exercise,
i.e.,
  
St · (1 + Rf )dt − St+dt
d u
Ct = max u
Ct+dt
u
St+dt − St+dt
d u
Discrete lattice is a stochastic process, where the stochas-
tic variable can change only after passing certain time-step
(stepping time) and can take on given number of new val-
ues. A given time period (T − t), during which the stochastic
process is simulated, is divided into finite number of time
steps where dt is the length of one discrete time step (time
interval). For any discrete moment at time t has the stochas-
tic process at t + dt (i.e. after passing stepping time) finite
possible number of values which can take on. According to
the number of values at the end of stepping time we work
with the following processes: binomial (at t + dt takes on
two values), trinomial (at t + dt takes on three values) or
multinomial (at t + dt takes on n values), see Fig. 1.
  
St+dt − St · (1 + Rf )dt
+ Ct+dt
d
(1 + Rf )−dt ; IVt ,
St+dt − St+dt
d

and after simplification,

Ct = max[(Ct+dt
u
· pu + Ct+dt
d
· (1 − pu )) · (1 + Rf )−dt ; IVt ].
(2.7) 1 More details are available in Hoek and Elliot (2006).
Real options valuation with changing volatility 13

Simulation via binomial lattice is the simplest discrete t t + dt

process. Here, the value of underlying (random) asset takes u . St
on at time t the value St ; at the end of discrete interval (i.e. pu
u
after passing stepping time) it can either jump up to St+dt or
d St
down to St+dt with some transition (risk-neutral) probability.
If the process can take on only positive values (typical for
pd = 1 - pu d . St
most financial variables), we work with geometric version,
where it holds for upward jump,
Figure 2 One period binomial lattice (geometric process).
u
St+dt = u · St (3.1)
t t + dt
and downward jump,
St + u
pu
d
St+dt = d · St (3.2)

and where u(d) are up and down factors. For these two fac-
tors it holds following: u ≥ 1; 0 < d ≤ 1 and d < erf dt < u. The
upward and downward factors u and d and transition (risk- pd = 1 - pu St - d
neutral) probabilities are set uniquely in order to determine
the evolution of underlying asset. Due to the fact that Figure 3 One period binomial lattice (arithmetic process).
expected return of any asset is assumed to be risk-free, the
t t + dt t + 2dt
expected value at the end of discrete step equals St · erf ·dt .
It follows that the expected value of the underlying asset u2 . St
u . St
can be written as,

E(St+dt ) = St · erf ·dt = pu · u · St + (1 − pu ) · d · St (3.3) St d . u . St

d . St
and after some rearrangements,

erf ·dt = pu · u + (1 − pu ) · d (3.4) d2 . St

From (3.4) the risk-neutral probability of upward jump pu is Figure 4 Two-period recombining binomial lattice (geometric
given as, process).

erf ·dt − d In situation, that the simulated process can take on both
pu = (3.5)
u−d positive and negative values, we work with arithmetic ver-
u
sion, where St+dt = St + u and St+dt
d
= St − d, see Fig. 3.2
and for downward jump must follows,

pd = (1 − pu ). (3.6) Simulation via binomial lattice with volatility

change
The variance of the underlying asset between two sub-
sequent discrete nodes at time t and t + dt is  2 dt. And
If we assume the constant volatility  over the period (T − t),
because the variance of random variable is generally given
the up and downward factors given according to (3.10) and
as  2 (S) = E(S2 ) − [E(S)]2 , it is possible to write
(3.11) are constant throughout the whole lattice model and
2
 2 dt = pu · u2 + (1 − pu ) · d 2 − [pu · u + (1 − pu ) · d] . (3.7) due to (3.9) it holds u · d = d · u = 1, which follows in the result
the lattice recombines. This means that the nodes recon-
Substituting for pu from (3.5)—(3.7) and after some rear- nect, i.e. St+2dt = u · d · St or St+2dt = d · u · St . Furthermore, the
rangements we get, value of the underlying asset in any node of the binomial
lattice can be expressed as,
 2 dt = erf·dt · (u + d) − u · d − 2 · erf·dt . (3.8)
St+i·dt = uj · d i−j · St (3.12)
Solving (3.4) and (3.8) and under the condition,
If (3.10) and (3.11) are unchanged and under the assump-
1 tion of constant risk-free rate, the transition probabilities
u= , (3.9)
d between any two subsequent nodes according to (3.5) and
(3.6) are constant, as well. Fig. 4 illustrates two-period
we get for upward and downward factors u and d following
recombining binomial lattice can be depicted as it is shown
formulas,
in Fig. 4.
√
When an up move followed by a down move does not
u = e· dt
, (3.10)
√
reconnect in the same node as a down move followed by an
−· dt
d=e . (3.11)

Fig. 2 shows one period binomial lattice with geometric 2 More details on derivation can be found in Tichý (2008), Hull

process. (2014), etc.

14 M. Čulík

t t + dt t + 2dt dt 1 dt 2 dt 3

u2 . St
u . St

u . d . St
St
d . u . St
d . St

d2 . St

Figure 5 Two-period non-recombining binomial lattice (geo-

metric process).

up move, i.e. St+2dt =

/ u · d · St or St+2dt =
/ d · u · St , the lattice
is called non-recombining. Non-recombining lattice is used
for analysis when there are multiple sources of uncertainty
or when volatility changes over time. The main difference
between recombining and non-recombining lattice is, that
the lattice with n periods the recombining have (n + 1) final
unique values, whereas non-recombining 2n values, which
are not unique. Fig. 5 shows two-period non-recombining
binomial lattice.
If the assumption of constant volatility is relaxed, it fol-
lows that upward and downward factors according to (3.10)
and (3.11) are not constant throughout the lattice any more.
The same is true about the transition risk-neutral proba-
bilities. In such situations, there are a few ways how to
overcome this issue: (a) for each period and volatility cal-
culate corresponding upward and downward factors; the
same is true about the transition probabilities (b) set the
transition probabilities pu = pd = 0.5 throughout the binomial
lattice and calculate for each period upward and downward
factors according to given volatility,
√ ing into (3.10) and (3.11) we get u = 1.284 and d = 0.7788.
(rf − 2 /2)·dt+ dt
u=e (3.13)
√
− 2 /2)·dt−
d = e(rf dt
(3.14)
or (c) the size of up and down movements and their cor-
responding transition probabilities are constant throughout
the lattice, but the time periods are of unequal length.
When volatility is high, the time periods are short, so that
the state variable changes frequently by the standardized
amount. When volatility is lower, the periods are longer so
that the changes in the state variable are less frequent.3
This binomial lattice is presented in Fig. 6.
Application — valuation American real option
valuation with changing volatility
Figure 6 Three-period recombining binomial lattice with
unequal length of time steps.
risk-free rate is rf = 8% p.a. and the annual volatility  = 25%.
The illustration example is structured as follows:
I. first, it is assumed that the volatility is constant,
II. next, volatility of cash flow increases as the project
expected end-life is approaching,
III. in the end, volatility of cash flow increases is assumed
again, for problem solution, an approach suggested by
Guthrie (2011) is employed.
Problem solution I
Problem solution is decomposed into the following steps:
(a) Calculation of upward and downward factor. Substitut-
(b) Calculation the risk-neutral probabilities. Applying (3.5)
and (3.6) we get following: pu = 60.27% and pd = 39.73%.
(c) Simulation of the underlying asset via the recombining
and non-recombining lattice.
(d) The intrinsic value calculation. For option to expand it
is defined as IVt = max(Vt − IE ; 0).4
(e) Option value calculation according to (3.7) by applying
backward-induction approach with risk-neutral proba-
bilities.
Following Fig. 7 shows numerical results; Fig. 8 shows
the histogram of end node values for recombining and non-
recombining lattice. The results obtained are identical no
matter which approach is used (option value equals 45 c.u.).

This part of the paper is focused on the application of dis- Problem solution II
crete binomial lattice on the real option valuation (option to
expand a project). The option is an American-type option,
Real option valuation with changing volatility includes fol-
i.e. the project can be expanded at any time during the
lowing steps:
expected life span. It is assumed that the underlying asset
is the cash flow generated by the project; the initial value
FCF0 = 100 c.u., and evolves according to the GBM. Company (a) Calculation of upward and downward factors for each
has the option to expand the project at any time during period and volatility according to (3.10) and (3.11).
the life span with the costs on expansion IE = 80 c.u. The Recall, that the volatility  1 applies for the first two

3 For more details and mathematical background see Guthrie 4 For more details see for example Trigeorgis (1999), Trigeorgis

(2011) or Haahtela (2010). (2000) Mun (2003) or Mun (2005).

Real options valuation with changing volatility 15

Non-recombining underlying asset lacce Non-recombining intrinsic value lace Non-recombining valuaon lace

272 192 192

212 132 138
165 85 85
165 85 97
165 85 85
128 48 55
100 20 20
128 48 66
165 85 85
128 48 55
100 20 20
100 20 34
100 20 20
78 0 11
61 0 0
100 20 45
165 85 85
128 48 55
100 20 20
100 20 34
100 20 20
78 0 11
61 0 0
78 0 21
100 20 20
78 0 11
61 0 0
61 0 6
61 0 0
47 0 0
37 0 0

Recombining underlying asset latce Recombining intrinsic value lace Recombining valuaon lace

272 192 192

212 132 138
165 165 85 85 97 85
128 128 48 48 66 55
100 100 100 20 20 20 45 34 20
78 78 0 0 21 11
61 61 0 0 6 0
47 0 0
37 0 0

Figure 7 Real option valuation lattice (recombining and non-recombining lattice, constant volatility).

6 3

4 2
Frequency

Frequency

2 1

0 0
37 62 100 165 272 37 61 100 165 272
end node values end node values

Figure 8 End node values of underlying asset value for non-recombining lattice (left) and recombining lattice (right).

Table 1 Up (down) ward factors and transition probabilities for given volatility level.

Volatility (%) Period Upward factor (u) Downward factor (d) pu (%)

1 40 0—1 and 1—2 1.4918 0.6703 50.3

2 45 3 1.5683 0.6376 47.9
2 50 4 1.6487 0.6065 45.7
16 M. Čulík

Non-recombining underlying asset lace Non-recombining intrinsic value lace Non-recombining valuaon lace

575 495 495

349 269 275
212 132 132
223 143 154
234 154 154
142 62 68
86 6 6
149 69 91
259 179 179
157 77 83
95 15 15
100 20 42
105 25 25
64 0 11
39 0 0
100 20 52
259 179 179
157 77 83
95 15 15
100 20 42
105 25 25
64 0 11
39 0 0
67 0 22
116 36 36
70 0 15
43 0 0
45 0 7
47 0 0
29 0 0
17 0 0

Recombining underlying asset lace Recombining intrinsic value lace Recombining valuaon lace

575 495 495

349 269 299
223 259 143 179 177 179
149 157 69 77 104 94
100 100 116 20 20 36 60 49 36
67 70 0 0 26 15
45 47 0 0 7 0
29 0 0
17 0 0

Figure 9 Real option valuation lattice (recombining and non-recombining lattice, increasing volatility).

Table 2 Up (down) ward factors and transition probabilities for given volatility level.

Volatility (%) Period Upward factor (u) Downward factor (d) pu (%)

1 40 0—2 1.4918 0.6703 50

2 45 3 1.5353 0.6242 50
2 50 4 1.5762 0.5798 50

periods,  2 for period three and  3 for period four. of the recombining and non-recombining underlying asset
Results are summarized in the following Table 1. lattice.
(b) Simulation of the underlying asset via the recombining
and non-recombining lattice.
(c) The intrinsic values calculation. Problem solution III
(d) Option value calculation according to (3.7) by applying
backward-induction approach with risk-neutral proba-
Real option valuation with changing volatility includes fol-
bilities.
lowing steps:

Fig. 9 shows resulting lattices; Fig. 10 shows the

histogram of end node values for recombining and non- (a) Calculation of the upward and downward factors for
recombining lattice. The results obtained are no more each period and volatility according to (3.13) and (3.14);
identical; the difference is caused primarily by the larger the transition probability is set to equals 50% for all
differences in the end nodes values (and their frequencies) periods, see Table 2.
Real options valuation with changing volatility 17

3 3

2 2

Frequency
Frequency

1 1

0 0
17 39 43 47 86 95 105 116 212 234 259 575 37 61 100 165 272
End node values end node values

Figure 10 End node values for non-recombining lattice (left) and recombining lattice (right).

Non-recombining underlying asset lace Non-recombining intrinsic value lace Non-recombining valuaon lace

539 459 459

342 262 266
198 118 118
223 143 153
219 139 139
139 59 64
81 1 1
149 69 89
242 162 162
154 74 79
89 9 9
100 20 40
98 18 18
62 0 8
36 0 0
100 20 51
242 162 162
154 74 79
89 9 9
100 20 40
98 18 18
62 0 8
36 0 0
67 0 21
109 29 29
69 0 13
40 0 0
45 0 6
44 0 0
28 0 0
16 0 0

Figure 11 Real option valuation lattice (non-recombining lattice, increasing volatility).

(b) Simulation of the underlying asset via the non- 2

recombining lattice. Due to the fact that the u · d =/ 1,
it is not possible to construct the recombining lattice.
(c) The intrinsic value calculation.
Frequency

(d) Option valuation according to (3.7) by backward-

1
induction approach and applying risk-neutral probabili-
ties.

0
Results are again depicted in the following Fig. 11; Fig. 12 16 36 40 44 81 89 98 109 198 219 242 539
shows frequency of underlying asset end node values. It is End node values
apparent that this approach provides the same results as the
Figure 12 End node values of underlying asset for non-
one applied in Problem solution II.5
recombining lattice.

Conclusion
5 Small difference in the results is caused by the number of the
steps in valuation lattice. For five and more steps the results world This paper focuses at the real option valuation under chang-
be identical. ing volatility. Change in the volatility structure (i.e. change
18
in project cash flows riskiness) is a typical feature for most
of the long-term project, where the prediction of the cash
flows in the far future is difficult and associated with the
higher risk.
Due to the fact that most real options are American-style
options, there are discrete binomial models applied. More-
over, other option valuation models (like B—S model) rely on
some assumptions (valuation European-style options, con-
stant volatility, risk free rate) and their application may be
limited for real options issues solutions.
It has been shown that, under changing volatility
application of non-recombining lattice with risk-neutral
probabilities is a useful tool helping the analysts to over-
come the option-valuation problems associated with the
variable parameters.
There were two approaches employed to evaluate real
option with the volatility change. The former one is based on
the assumption that the entire lattice is divided into stages
with constant volatility; at the end of the constant volatility
period, each resulting point becomes starting point of a new
lattice. For each period, corresponding up and down factors
and transition probabilities must be calculated. The latter
approach sets the transition probabilities to 50% throughout
the entire lattice and adjusts the up and downward factors
with respect to the volatility during given period. Due to
the fact that the centrality is broken, only non-recombining
lattice can be used. Anyway, for sufficient number of steps
both approaches provide the same results.
Conflict of interest
The author declares that there is no conflict of interest.
Acknowledgements
This paper was supported within Operational Pro-
gramme Education for Competitiveness — Project No.
CZ.1.07/2.3.00/20.0296 and the Project No. GP14-15175P.
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