AN ARBITRAGE-FREE APPROACH TO QUASI-OPTION VALUE; Proceedings of the Fifth Joint Conference on Agriculture, Food, and the Environment, June 17-18, 1996, Padova, Italy
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In the presence of uncertainty and irreversibility, dynamic decision problems should not be solved using expected net present value analysis. The right to delay a decision can be valuable. We show that the value of this right equals Arrow and Fisher's (1974) quasi-option value. In a discrete model we show how to derive quasi-option value using methods from finance, methods that remove altogether the need to take expected values of future stochastic variables. Two main findings are presented. First, if the stochastic dynamic process underlying the problem is known, the Arrow and Fisher and Henry (1974) result that improper use of net present value leads to too much early development, is correct. Second, if the process is not known perfectly, their result can be incorrect in the sense that net present value methods lead to the correct outcome while the dynamic rule does not.