Abstract
One of the consequences of the Subprime crisis is the accentuated need for financial innovations, which allow for the proper evaluation of investment projects. In this chapter, the innovation of using variable interest rates in real options pricing methods is presented in theory as well as in practice. The big advantage of these methods over the traditional Net Present Value (NPV) approach is that they allow to include the project’s optionalities into its evaluation. But traditional methods of real options pricing use a constant risk-free interest rate for discounting. This is clearly not appropriate when looking at long-term projects, typical examples of which are pharmaceutical R&D projects or oil drilling endeavors. The longer the runtime of a project, the more options are likely to arise. This was particularly obvious in the last decade, when the interest rate development showed steady upward trends followed by abrupt downward movements. There is no doubt that movements like these have a strong impact on the evaluation of investment projects. This chapter describes one method of how to determine non-constant risk-free rates and presents two case studies that analyzed various types of real options.
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This function is not the short-rate process (r t ) t≥0, which will be introduced later, but just a time-dependent function.
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Schulmerich, M. (2011). Creating Corporate Value with the Exposure to Financial Innovations: The Case of Interest Rates. In: Hommel, U., Fabich, M., Schellenberg, E., Firnkorn, L. (eds) The Strategic CFO. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-04349-9_17
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