Real options valuation with changing volatility

SummaryThis 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.