Minimizing Hedging Error in Real Options Pricing
A method for minimizing hedging errors in real options pricing using a surrogate tradable asset to hedge non-traded project risk, with dynamic hedge adjustment based on correlation.
This paper proves a method for minimizing hedging errors when pricing real options. The fundamental challenge: real investment projects are not traded, making it impossible to form a perfect replicating portfolio as Black-Scholes theory requires.
The Surrogate Hedging Approach
The proposed solution uses a surrogate, tradable asset — chosen for its correlation with the non-traded project — to construct an approximate hedge. The hedge ratio is adjusted dynamically based on the correlation between the surrogate and the project asset, minimizing residual variance.
Technical Framework
Using Black-Scholes pricing logic adapted to real-world limitations, the model shows how firms can better control valuation uncertainty when making strategic investment decisions. The variance-minimization objective provides a principled criterion for selecting among candidate surrogate assets.
Practical Significance
By formalizing the hedging problem for non-traded assets, this framework helps practitioners produce real options valuations that are more stable and defensible — particularly important in contexts where the option value must be communicated to executives or presented to investment committees.