Abstract

This paper aims at the valuation of real options with changing volatility. Volatility change is a typical feature of real investment projects, where the riskiness of cash flow generated by the project can change significantly during the project life span. In this paper, there is explained how the problem of changing volatility can be considered if binomial lattice and replication strategy is used for real option valuation. There are recombining and non-recombining lattice used and constant and increasing volatility are analysed and results compared. In situation when volatility is changing, two approaches overcoming this problem are employed and compared.

Abstract

Time-varying parameter models have been widely spread in macroeconomic studies carried out over the past 20 years. Following the seminal papers in this field, various authors began to apply such models to analyze the time-varying behavior of such macroeconomic parameters as volatility, long-term economic growth, trend inflation, the persistence of inflation and oil prices, as well as the dependence of the main macroeconomic variables on oil prices. This review provides a methodological basis for using time-varying parameter models as one of the underlying tools of macroeconomic modeling and forecasting, as such models allow taking into account temporary changes in the relationships between different variables.