Using Risk-Adjusted Interest Rates in Option Pricing
An innovative approach to option valuation incorporating project-specific risk adjustments via CAPM, linking market returns and risk premiums into a consistent pricing formula.
This research presents an innovative approach to option valuation by incorporating project-specific risk adjustments. The methodology establishes connections between the Capital Asset Pricing Model (CAPM) framework and option pricing mechanics.
The Core Idea
Standard option pricing theory discounts expected payoffs at the risk-free rate, using risk-neutral probabilities to make this internally consistent. This paper modifies the approach to better reflect the actual risk profile of non-traded underlying assets — a key practical challenge in real options applications.
Methodology
The approach builds from the CAPM model, linking market returns, project returns, and risk premiums into a consistent option pricing formula. It leverages mathematical relationships between objective probabilities and risk-neutral probabilities to enhance valuation accuracy.
Practical Significance
This framework addresses a significant gap in traditional option pricing by accounting for the genuine risk profile of underlying projects. Valuations produced this way more closely align with real-world investment scenarios and the risk-return tradeoffs that practitioners actually face.