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ACCA Strategic Professional · Advanced Financial Management · Application of option pricing theory in investment decisions

A company values a project's option to delay using the Black-Scholes model. Which of the following is a recognised limitation of applying this model to real options?

A key limitation is that project volatility is not directly observable because the underlying asset is not traded, so it has to be estimated, often from proxies. This makes the input subjective and the resulting option value less reliable.

  1. AThe model cannot value a call option when the exercise price is positive
  2. BThe model assumes the underlying asset's volatility is easily observable, which is rarely true for a non-traded projectCorrect
  3. CThe model requires that the option can be exercised at any time before expiry, which real options always allow
  4. DThe model ignores the risk-free rate of interest

Explanation

Real projects are not traded, so the volatility of the underlying (project value) must be estimated, often from proxy firms, which makes inputs subjective. The model does use the risk-free rate, and it values European options exercisable only at expiry, so the other statements are false.

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