Valuing risky projects: Option pricing theory and decision analysis


Book Section

© 1995. Institute for Operations Research and the Management Sciences. All rights reserved. In the academic literature and professional practice, there are a number of alternative and apparently competing methods for valuing risky projects. In this paper, we compare and contrast three different approaches: risk-adjusted discount-rate analysis, option pricing analysis, and decision analysis, focusing on the last two. We show that, in contrast to some of the claims made in the "real options" literature, when both option pricing and decision analysis methods are correctly applied, they must give consistent results. We also explore ways in which option pricing and decision analysis methods can be profitably integrated. In particular, we show how option pricing techniques can be used to simplify decision analyses when some risks can be hedged by trading and, conversely, how decision analysis techniques can be used to extend option pricing techniques to problems with incomplete securities markets.

Duke Authors

Cited Authors

  • Smith, JE; Nau, RF

Published Date

  • November 1, 2017

Book Title

  • Decision Science

Start / End Page

  • 71 - 92

International Standard Book Number 13 (ISBN-13)

  • 9781138730267

Citation Source

  • Scopus