Litigation Risk and the Valuation of Legal Claims: A Real Option Approach

Legal claims are increasingly being considered as an alternative asset class, however, there appears to be a lack of a standard methodology for valuing litigation risk. This paper proposes a dynamic real options framework for the valuation of legal claims, explicitly incorporating the uncertainty and sequential nature of litigation processes. We develop a continuous-time stochastic model that accounts for the main procedural milestones and uncertainties, enabling the simulation of diverse litigation trajectories to estimate the net present value of a claim. The model permits the decision-maker to optimally continue or abandon the litigation at various stages, thereby capturing the embedded option value and enhancing claim valuation. This approach offers a novel risk management and valuation tool for a range of stakeholders, including investors, third-party funders, claimants, defendants, legal practitioners, auditors, and insurers. We demonstrate the practical relevance of the methodology by applying it to an actual international investment arbitration case.