Production-Based Option Pricing

We show that a structural model incorporating firms’ real options and financial leverage decisions can generate forward-looking equity distributions of various shapes, resulting in highly flexible implied volatility surfaces. In contrast, exogenously specified models with stochastic volatility and jumps can only generate smiles and downward-sloping curves. We explain the observed negative relationship between downward sloping implied volatility surfaces and the value of real options: real options contribute positively to equity skewness, and more so the more convex their payoff, which is the case when the real option is “at-the-money” and has the lowest value.