REAL OPTION ANALYSIS IN INCOMPLETE MARKETS: THE PRICING OF SIMPLE AND COMPOUND OPTIONS

In modelling real estate assets, the assumption of market completeness is violated. In this work we introduce indifference pricing in the valuation of development projects for the first time in the context of real option analysis. We model both a simple call option to defer and a compound put option to return the land to the local authority. Using a real estate fund index as correlated asset, we show option prices and their sensitivities to parameter values. Particularly, we find that for incomplete markets the convergence to the Black-Scholes value seems to require a higher number of steps, and initial price oscillations tend to be definetely smaller than for complete markets. This result would suggest the need to revise investment strategies more frequently.