Valuing Risky Projects: Option Pricing Theory and Decision Analysis

James E. Smith and Robert F. Nau (Management Science 41:5 795-816)

Abstract: 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 techniques can be profitably integrated. In particular, we show how option pricing techniques can be used to simplify decision analysis 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.

Key words: valuation, option pricing theory, decision analysis

Comments: This paper rigorizes and extends results originally developed in Section 5 of "Arbitrage, Rationality, and Equilibrium" (Nau and McCardle 1991). A continuous-time extension and application is described in a more recent working paper by Smith and McCardle (1995) entitled "Valuing Oil Properties: Integrating Option Pricing and Decision Analysis."