Extended Binomial Trees for Real Options Valuation in E&P Projects

Abstract

Abstract The following paper addresses the limitations of the Binomial Tree Approach for Real Options Valuation (ROV) when used as a direct extension from Financial Options Valuation (FOV), since the strong assumptions that support the theory do not always apply to investments in real assets. Subsequently, a solution for these problems is proposed using an extension of the binomial approach, which complies with the conditions that this theory imposes on Financial Options Valuation, and hence, on Real Options Valuation. The proposed approach, the Extended Binomial Trees (EBT), permits sign changes to occur inside the underlying asset's tree, unlike the traditional binomial approach, and prevents skewness and kurtosis from happening in the rate of return distribution. This methodology is then presented using as framework the valuation of redeveloping the Sardinata field, in Colombia, and the results are presented in a comparative chart along with the ones obtained by means of the traditional binomial approach.