On static hedging, real options and valuation of cash flows with skewed distributions

Draft. We combine static hedging and real options valuation ideas to build a capital budgeting technique. Here one applies the market information of derivative prices on a traded 'quasi twin security' to benchmark a single-step stochastic cash stream. We provide a transparent, more or less closed-form solution for valuing these streams. The fundamental properties of this valuation rule are then studied. The derivation of the pricing rule is developed in such a way as to generalize intuitive real option considerations to continuous state step-by-step. We also discuss some required mathematical finance machinery as well as results of Breeden-Litzenberger type.