. Valuing an american option: j&v drilling company has recently acquired a lease to drill for natural gass in a remote refion of southwest Louisiana and southeast Texas. The area has long been known for oil and gas production, and the company is optimistic about the prospects of the lease. The lease contract has a three-year life and allows j&b to begin exploration at any time up until the end of the three-year rerm.
J&b's engineers have estimated the value of $25 million on it, on the condition that explorations begin immediately. The cost of developing the property is estimated to be$23 million (regardless of when the property is developed over the next thre years). Based on historial volatilities in the returns of similar investments and other relevant information, j&b's analysts have estimated that the value of the investment opportunity will evolve over the next three years.
The risk-free rate of interest is currently 5%, and the risk-neutral probability of an uptick in the value of the inestment is estimated to be 46.26%.