The impact of the interest rate volatility on the valuation of investment strategies

One of the most challenging issues in management is the valuation of investment strategies. Indeed, there are several kinds of projects, for example those concerning brand extension, information technology and patent-protected R&D projects, that are strongly affected by uncertainty, see e.g. Santos et al. (2014), Kalhagen and Elnegaard (2002), Charalamopoulos et al. (2011), Manley and Niquidet (2010), Bernardo et al. (2012) and Baldi and Trigeorgis (2009). When undertaking investments such as the aforementioned ones, which are characterized by a long-term horizon, a firm has also to face the risk due to the interest rates. In fact, interest rates do not remain constant over time but experience up-and-down movements and volatility that may become significant especially in the long run. In this work, we propose to value investment strategies subject to interest rate risk using a Real Option approach, see, e.g., Schulmerich (2010). In particular, we model interest rates according to a stochastic process of Vasicek type and we calibrate it to the Euribor/Eurirs indexes. Such a process is then integrated in a Black-Scholes framework, which allows us to obtain an explicit formula for valuing various kinds of projects (such as option to defer and option to expand). A numerical application is presented that illustrates the proposed real option approach from the practical point-of-view.