Comparing mean reverting versus pure diffusion interest rate processes in valuing postponement options
Abstract
Using a simulation approach, we analyze the effect of mean reversion on the value of capital budgeting postponement options. Two interest rate processes are compared: a pure diffusion process and a stochastic mean reversion process. The mean reverting process generates interest rate paths that are consistent with historically observed rates. Because option values depend not only on the variance of rates but also on the pattern of rate diffusion across time, a pure diffusion process may lead to significant mispricing of options if the true process is mean reverting. We analyze mispricing for different yield curve scenarios and as a function of the differencing interval used to measure volatility.
Publication Title
Quarterly Review of Economics and Finance
Recommended Citation
Spahr, R., & Schwebach, R. (1998). Comparing mean reverting versus pure diffusion interest rate processes in valuing postponement options. Quarterly Review of Economics and Finance, 38 (3 Part.1), 579-598. https://doi.org/10.1016/s1062-9769(99)80091-x
