Displaced Diffusion Binomial Tree for Real Option Valuation

This paper describes a real options valuation method for situations where the underlying asset may have negative values and the underlying project present value distribution is something of the shape between normal and lognormal distribution causing skewness to the rate of return distribution. The underlying project value is assumed to follow a displaced diffusion process with a dynamic path having up and down movements with properties of both additive and multiplicative processes. Therefore the approach takes into account the changing volatility according to the level of the underlying asset value. A recombining binomial tree solution for the displaced diffusion is presented with a managerially applicable simulation based parameterization. The results suggest that the assumptions of geometric Brownian motion and a lognormal distribution may not be sufficient for practical cash flow simulation based real option valuation