Thursday July 24, 2014
9:00 - 10:00 Registration
9:00 - 12:00 Free Tutorials (Optional) – Part of the Managerial Program
9:00 - 9:45 Valuing Real Options Using Binomial Trees
Lenos Trigeorgis (U of Cyprus and King's College London, UK)
9:45 - 10:30 Valuing Real Options Using Simulation
Luiz E. Brandão (PUC-Rio, Brazil)
10:30 - 11:10 Morning Coffee Break
11:10 - 11:55 Case Studies Using Binomial Trees and Simulation
Marco AG Dias (Petrobras, Brazil)
12: - 1:45 Luncheon
1:45 - 2:00 President's Welcome
2:00 - 3:40 Empirical Evidence/Growth Options
Chairperson: Lenos Trigeorgis (University of Cyprus and King's College, London)
Oscar Miranda (PUC-Rio, Brazil)
Luiz E. Brandão (PUC-Rio, Brazil)
In this paper we develop a dynamic model to assess the financial viability of a mining project in exploration stage using the real options approach. The model simulates the decision making process and determines the value of the real options associated with the mining project. The firm has the option to defer investment, and once invested, to abandon or expand the project. On the other hand, considering that the firm is listed in the stock market, the model assesses the likely impact of these options on the firm's market value. The results show that the combined real options associated with the project have a significant impact on its value, which indicates the firm's stock is undervalued by approximately 40%.
Eduardo Navarrete (Universidad de la Frontera, Chile)
The simple and multiple optimal rotation harvests pine stands models under Brownian price diffusion and Logistic or Gompertz wood stock processes for the deterministic and stochastic case, are formulated and solve for a Chilean company pine stands harvests. The applications of these models show that the company optimal cut policy for radiate pine stands validate the simple rotations stochastic models. The Logistical wood stock diffusion model optimal cuts underestimate the company actual cut 2.3% and the saturation volume in 4.5%. The Gompertz diffusion model overestimates the actual cut in a 1.2% and the saturation volume in 0.5%. Obviously the company actual cut policy does not follow the theoretical multiple rotations optimal policies: The Faustmann stochastic models underestimate the company optimal cut by 40.4% in the Logistic case and by 35.8% in the Gompertz model case. These discrepancies can be explained by the fact that the company considers just simple rotation planning horizons to evaluate the harvesting time of the pine stands.
Luca Del Viva (ESADE Business School, Spain)
Eero Kasanen (AALTO School of Business and ESADE Business School, Finland)
Lenos Trigeorgis (University of Cyprus and King's College, Cyprus)
We add to the explanatory theory of skewness showing how real options generate convexity of payoffs leading to skewness in returns. We document empirically that growth option variables are significant, positive and robust determinants of idiosyncratic skewness, over and above previously reported determinants. We further confirm that expected long-term idiosyncratic skewness deriving from growth options commands a negative return premium. These results suggest a behaviorally rational transmission mechanism from real options to stock returns through enhanced idiosyncratic skewness.
Lenos Trigeorgis (King's College London and University of Cyprus, Cyprus)
Neophytos Lambertides (Cyprus University of Technology, Cyprus)
Luca Del Viva (ESADE Business School, Spain)
We examine the combined impact of growth options and distress on expected idiosyncratic skewness and whether the negative return on skewness is driven by growth options and distress risk. We show that growth and reorganization options lead to more convex value and increased skewness for active levered equity returns. We find empirically that the negative relation between growth options or distress risk and stock returns can be attributed to the more skewed distribution for growth and distressed firms. Our study offers deeper rationale behind these twin "puzzling" phenomena suggesting that growth and distress justify lower, rather than higher, expected returns.
3:40 - 4:10 Afternoon Coffee Break
4:10 - 5:00 Keynote Address
Marco A.G. Dias (Petrobras and PUC-Rio, Brazil)
Application of Real Options in Petroleum & Energy
5:00 – 6:00 Panel Discussion
Real Options Application: Successes and Impediments
Moderator: Cecilia Maya Ochoa (CFO XM, Colombia)
Luiz Brandão (PUC-Rio, Brazil)
6:00 – 7:15 Networking Reception
Friday July 25, 2014
9:00 - 10:15 Parallel Sessions
I Natural Resources & Energy
Chairperson: Marco A.G. Dias (Petrobras, Brazil)
Rafael Igrejas (PUC-Rio, Brazil)
Leonardo Lima Gomes (PUC-Rio, Brazil)
Luiz Eduardo Teixeira Brandão (PUC-Rio, Brazil)
Power purchase and sale contracts in Brazil, have been receiving attention in the last few years due to the high volatility of electricity spot price (PLD) and the regulatory constraints to operate in the brazilian electricity market. In this scenario, even when contract content is clearly understood by the parties, uncertainties are commonly not well measured and flexibilities are not correctly priced. One reason is the limitation of traditional financial techniques for pricing contracts which often did not adequately take into account some important features, mispricing embedded flexibilities. These flexibilities can be seen as options by the purchasers, in the way to choose the amount of energy to be supplied (amount option) or to reduce the amount or even to interrupt the supply during a predetermined interval (reduction option). In this working progress paper, we present what is intended to investigate in the final study about valuing these flexibilities in bilateral contracts in the Brazilian electricity market, using real options approach. These flexibilities are modeled as compound European call and put options, under uncertainties of monthly energy price and energy demand. In the paper, we also intend to discuss new perspectives for independent stochastic variables modeling to value options embedded in bilateral contracts.
Xinhua Qiu (China University of Petroleum at Beijing, China)
Zhen Wang (China University of Petroleum at Beijing, China)
Deep water oil and gas projects embody high risks from geological and engineering aspects, which exert substantial influence on project value. And the risks may be converted to additional value of the project in the case of flexible management. We analyze project management flexibility, extend the classical real options model to multi factors model which contains oil price, geological and engineering uncertainties, and the model is applied to evaluate deep water oil and gas project with numerical analytical method. Compare with other methods and models, this model comprises more project information. It reflects the influences on the project value not only from oil price changes, but from geological and engineering uncertainties, it provides more accurate and reliable valuation information for decision making.
Sergio Cabrales (Universidad de los Andes, Colombia)
Rafael Bautista (Universidad de los Andes, Colombia)
This paper develops a model using real option for valuing nonrenewable resources given geological constraints and the endogenous production costs. For oil production companies, we found endogeneity of the costs of geology, drilling, transportation and production. The possible explanation for the endogeneity of the cost goes from the problem of hold up to the ratio of the raw materials used in the industry with the spot price of oil. We assume a stochastic process for spot oil prices and there are no ways to improve the reserves (such as fracturing, chemical stimulation, injection wells, etc).
II Theoretical Issues
Chairperson: Andreas Welling (Otto-von-Guericke-University Magdeburg, Germany)
Andreas Welling (Otto-von-Guericke-University Magdeburg, Germany)
Elmar Lukas (Otto-von-Guericke-University Magdeburg, Germany)
Stefan Kupfer (Otto-von-Guericke-University Magdeburg, Germany)
Only recently the general assumption of a negative investment-uncertainty relationship has been questioned in the literature and some examples of a nonmonotonic investment-uncertainty relationship have been found. By analyzing the influence of uncertainty on the probability to invest in a given time we show that the non-monotonicity of this relationship is not an exemption but the rule. Furthermore, we analyze and discuss the strengths and weaknesses of the different interpretations of the investment-uncertainty relationship and verify by an example that the investment-uncertainty relationship may stay ambiguous as its sign critically depends on the interpretation as well as on time.
Gonzalo Diaz-Hoyos (Ecopetrol, Colombia)
Ignacio Velez-Pareja (Master Consultores, Colombia)
Tax savings valuation is crucial for discounted cash flow valuation and WACC estimation. There is an ongoing debate about the appropriate discount rate for tax savings under CAPM approach. On this paper we evaluate tax savings from a contingent claim approach in order to establish a framework which could be compatible with discounted cash flow valuation while being consistent with tax savings nature. We present two approach based on contingent claims with continuous real and risk neutral probabilities, and propose a strategy based on sequential portfolios of European options for its valuation. We state that the value of tax savings is the present value of tax savings, and provide a valuation formula that can be integrated with a traditional discount cash flow model under WACC and APV.
Jani Kinnunen (Åbo Akademi U., Finland)
Irina Georgescu (Academy of Economic Studies, Romania)
This paper studies ex-post financial ratios and real option values of Finnish exchange listed companies’ publicly available yearly financial data, i.e., financial statements and market valuations, using self-organizing map, SOM, an unsupervised neural network based tool for clustering, analysis and visualization of multidimensional data. In the unsupervised learning the training set contains only the selected input values and the SOM is to learn the data structure. We have selected the financial inputs in such a way that they include the key drivers of companies’ market values above their fundamental book values to get a proxy for their real options values. We interpret the visualized clustering results and argue that the method is applicable and valuable, in addition to general descriptive purposes, for private investors’, venture capitalists’ and corporate acquirers’ portfolio selection in their quest for upside potential. This opens up interesting future research opportunities from real options perspective laid out in this study.
10:15 - 10:45 Morning Coffee Break
10:45 - 12:00 Parallel Sessions
I Various Applications using Simulation
Chairperson: A. Mora-Valencia (EAFIT U., Colombia)
Rafael Rodrigues (Ibmec Business School, Brazil)
Luiz Ozorio (Ibmec Business School, Brazil)
Carlos Bastian-Pinto (Ibmec Business School, Brazil)
Luiz Eduardo Brandão (PUC, Brazil)
Fertilizers are extremely important to agricultural production worldwide due to the productivity improvements in cropping that it allows. This article uses the Real Options Theory to evaluate the switch-output option, ammonia or urea, in a nitrogen fertilizer plant. The Monte Carlo simulation method was used to define the value of the switch option in a fertilizer plant where the uncertainties considered are the prices of natural gas (main raw material), ammonia and urea, all of them following a mean reversion movement – MRM – as stochastic process. The results show that the option of the investor is valuable.
Dejan Podhraski (Institut for Public-Private Partnership, Slovenia, Slovenia)
Ales Berk (University of Ljubljana/Faculty of Economics, Slovenia)
Public-private partnerships as a form of financing usually provide solutions to public budget constraints and help improve cost and operating efficiency of large infrastructure project, which contribute to faster economic growth. However, they are not without controversies. Evaluations of financial results of such huge projects involving real options (usually in terms of government guarantees or put options) are still performed in a misleading manner, which may severely influence decision-making. In this article we present an illustrative example of valuation of a typical infrastructural project, compare and critically evaluate results obtained by Monte Carlo simulations (MCS) and Geometric Brownian motion (GBM). We argue that any project guarantee (option) with path-dependent payoffs, should always be evaluated using MCS. In a typical infrastructure project, GBM underestimates cash flows and overestimates value of guarantees of a public partner. In economic terms, this implies more implemented projects, which are urgently needed, and higher impact on well-being.
Victor Cohen Uller (Petrobas, Brazil)
Carlos Bastian-Pinto (Ibmec, Brazil)
Luiz Ozorio (Ibmec, Brazil)
The purpose of this paper is to value contractual options which allow the producer/exporter to sell its cargo at a marker oil price (WTI, Brent or LLS – a second north American marker oil) but to choose the mode convenient differential (or spread) up to the moment of delivery. This is done using monte carlo simulation after the stochastic model for the spread uncertainty has been determined.
II R&D and Learning Investments
Chairperson: Luiz Ozorio (IMBEC Business School, Brazil)
Gláucia Fernandes (Federal University of Juiz de Fora (UFJF), Brazil)
Fernanda Perobelli (Federal University of Juiz de Fora (UFJF), Brazil)
Luiz Brandão (Pontifical Catholic University of Rio de Janeiro (PUC-Rio), Brazil)
Rafael Igrejas (Pontifical Catholic University of Rio de Janeiro (PUC-Rio), Brazil)
This paper proposes a theoretical improvement to the valuation model of innovative projects and discusses its practical application. Our base model is the one of Silva and Santiago (2009) and its practical application is still in development in this extended abstract. We question some points of the model and include a minimum sales function, which decreases in time. In order to test the improved model, we intend to perform a financial evaluation of an existent project (fictionally called HBDO). This project has multiple sources of uncertainty and managerial flexibility at every stage of its revision. We expect conclude from de results that the Silva and Santiago improved model is the most appropriate for evaluating R&D projects in the context of development product with guaranteed market share.
Laura Delaney (City University London, United Kingdom)
This paper considers the impact of development cost uncertainty on an investor's investment timing decision when the project in question takes time to build and the market in which the investor operates is incomplete. Additionally, the future revenue that will be generated from the project when it has been fully developed is also uncertain.
Luigi de Magalhaes Detomi Calvette (PUC-RIO (Pontificia Universidade Catholica do Rio de Janeiro), Brazil)
This paper discusses the problem of optimizing the sequence of exploratory prospects considering its embedded real options, the potential learning effects and also synergy. The portfolio value is the objective function to be maximized and it obeys the concept that "the total is greater than the sum of its parts". The main objective is to optimize different portfolio sizes (the largest has 10 prospects) using Genetic Algorithms.
12:00 - 2:00 Luncheon
2:00 - 3:15 Parallel Sessions
I Strategic Perspectives
Chairperson: Arkadiy Sakhartov (The Wharton School, University of Pennsylvania, United States)
Malcolm Brady (Dublin City University, Ireland)
This paper examines the strategic use of temporary employment contracts as a means of dealing with uncertainty in the form of unrevealed employee ability. The paper puts forward a model of a temporary contract as a real option, specifically as a combination of a put option and a stock. The paper examines implications of this model for academic recruitment in regard to lecturers and post-doctoral researchers, and in regard to research intensive and teaching intensive institutions. The model has relevance more generally in employment situations where there is a large time-lag between recruitment of the employee and revelation of ability.
Arkadiy Sakhartov (The Wharton School, University of Pennsylvania, United States)
The study extends applicability of the strategic factor market theory to acquisitions of resources in the market for companies, contrasting with the view that efficiency of stock markets precludes strategizing in those markets. The field example illustrates that one aspect of firms‚Äô resources, their redeployability to new product markets, can be persistently underpriced by market investors. Furthermore, the simulation model demonstrates that the undervaluation can be predicted, specifying the undervaluation as a function of the observable resource properties. The model illuminates the redeployability paradox ― the same factors, making resources objectively more‒valuable, can also make them more‒undervalued in the stock market. The derived operationalization of the undervaluation is useful for empiricists testing implications of the strategic factor market theory and managers seeking for sources of abnormal returns.
Diana Constanza Restrepo Ochoa (Universidad Carlos III de Madrid, Spain)
Ricardo Correia (Universidad Carlos III de Madrid, Spain)
Juan Ignacio Peña (Universidad Carlos III de Madrid, Spain)
Javier Poblacion (Bank of Spain, Spain)
We build a Real Options model to assess the importance of private provision and the impact of expropriation risk on investment timing, investment volumes, governmental costs and social welfare. We consider two types of businesses (essential and non essential businesses) and two stages (operating and investment opportunities). Our results indicate that the importance of private provision is linked with efficiency of the private investor and the benefits of private provision are higher for essential businesses. When considering expropriation risk our results show that non essential businesses are more exposed to expropriation risk. Overall, although expropriation risk is associated with a reduction in welfare and in investment volumes it does not affect investment timing significantly.
II Competitive Games and Incomplete Information
Chairperson: Carlos Bastian-Pinto (IBMEC Business School, Brazil)
Nick Huberts (CentER, Tilburg University, Netherlands)
Kuno Huisman (CentER, Tilburg University, Netherlands)
Peter Kort (CentER, Tilburg University, Netherlands)
Herbert Dawid (Bielefeld University, Germany)
This paper studies asymmetric firms that consider an innovative investment in an established market. Conjoining capacity choice, asymmetry among firms, and an innovative market, brings up a new, more profound, model to evaluate firms' investing behavior in a competitive, uncertain dynamic duopoly setting. An investment comprises both optimal timing and setting capacity. We show that capacity choice induces some new results. In great contrast to models where capacity size is given, we find that larger firms have more incentives to invest and innovate. Larger firms moreover underinvest in order to obtain a temporary monopoly position. This leads to the general result that large firms lead innovation, but take the smallest stake on new products on established markets.
Maria Lavrutich (Tilburg University, Netherlands)
Kuno Huisman (Tilburg University, Netherlands)
Peter Kort (Tilburg University, Netherlands)
This article studies strategic investment behaviour of firms facing an uncertain demand in a duopoly setting. Firms choose both investment timing and the capacity level while facing additional uncertainty about market participants, which is introduced via the concept of hidden competition. We focus on the analysis of possible strategies of the market leader in terms of its capacity choice and on the influence of hidden competition on these strategies when there are only two places available on the market. The main result of this paper is that hidden competition generates a hysteresis or inaction region. In particular, the leader invests in a small market implementing the deterrence strategy as well as in the big market choosing the accommodation strategy. However for the case of the intermediate market the firms do not take any actions and prefer to postpone investment. This effect is robust to the relaxation of the limited market assumption, i.e. the hysteresis region still exists in a setting where there is a positive revenue for the third firm in the market.
Thomas Fagart (Université Paris 1, France)
In this paper, we develop and analyze a classic dynamic model of irreversible investment under imperfect competition and stochastic demand. We characterize the markovian equilibrium when player's strategies are continuous in the state variable. At the equilibrium, firms invest as quickly as possible in order to join a zone in the space of capacities where there is no competition pressure. Furthermore, the equilibrium as an efficiency property: the point of this area which is reach by the firms is the point which minimizes the investment cost of the all industry.
3:15 - 3:45 Afternoon Coffee Break
3:45 - 5:00 Parallel Sessions
I Environmental Investment & Policy
Chairperson: S.B. von Helfenstein (Value Analytics & Design LLC, United States)
S.B. von Helfenstein (Value Analytics & Design LLC, United States)
Almost fifty years ago Garrett Harding, in discussing human over-population, coined a phrase, the tragedy of the commons. This phrase has since been used to describe a dilemma in which the freedom of individuals to maximize their personal utility of common resources/goods (water, air, land, and so forth) leads to the destruction of those resources. Today, the ‚Äòtragedy‚Äô takes its most poignant forms in the large-scale use/abuse of natural resource inputs and the overwhelming accumulation of waste outputs accompanying mass urbanization. Although its locus initially resides in economic, socio-political, and ecological systems, in the end, it is also an engineering systems problem since many current and future solutions depend on engineering systems design and implementation. As a systems design/implementation problem, it is amenable to the consideration of optionality (i.e., flexibility), both at the level of the engineering system and that of the city. This paper is dedicated to the conceptual exploration of a single aspect of the problem – construction and demolition (C&D) waste. It examines current C&D waste management practice and proposes a taxonomy in which flexibility/optionality is utilized to transform failed C&D waste management systems into effective systems for resource recovery. A real-world case example is presented that demonstrates the attractiveness of a flexible C&D natural resource recovery system and the potential it offers to successfully address the problem.
Andreas Welling (Otto-von-Guericke-University Magdeburg, Germany)
Elmar Lukas (Otto-von-Guericke-University Magdeburg, Germany)
Stefan Kupfer (Otto-von-Guericke-University Magdeburg, Germany)
The economic success of green investments does not only depend on the uncertain economic development but also on future regime switches in the relevant legislation. As a result of political decision-making the latter are assumed to be rather ambiguous than uncertain. Based on the example of biologic fuel we develop a real options model that takes into account economic uncertainty as well as political ambiguity. We calculate the option value of the green investment and derive the optimal investment-timing strategy. Furthermore, we analyze both the sole as well as the combined influence of economic uncertainty and political ambiguity on these topics.
Mahdi Shahnazari (Murdoch University, Australia)
Adam McHugh (Murdoch University, Australia)
Bryan Maybee (Curtin University, Australia)
Jonathan Whale (Murdoch University, Australia)
Political uncertainty over global greenhouse gas (GHG) mitigation policy is likely to defer investment in cleaner technologies. It may also incentivise short-lived, high-cost interim investments while businesses wait for the uncertainty to subside. The range of possible policy responses to the issue has created uncertainty over the future of national mitigation pathways. Given that the electricity sector, globally, is a major emitter of GHGs, this represents a systematic risk to investment in electricity generation assets. This paper uses a real options analysis framework informed by a survey of experts conducted in Australia - used as a proxy to model the degree of the uncertainty- to investigate the optimal timing for investment in the conversion of a coal plant to a combined cycle gas turbine plant using the American-style option valuation method. The effect of market and political uncertainty is studied for the Clean Energy Act 2011 in Australia. Political uncertainty is addressed bi-modally in terms of: (1) uncertainty over the repeal of the carbon pricing policy, and (2) if it is repealed, uncertainty over the reinstatement of the policy, to represent the effect of electoral cycles and the possibility of more stringent future global mitigation efforts. Results of the analysis show that although political uncertainty with respect to GHG mitigation policy may delay investment in the conversion of the coal plant, expectations over the reinstatement of the carbon pricing reduces the amount of option premium to defer the conversion decision.
II Best Student Paper Award Session
Chairperson: Luiz E. Brandão (PUC-Rio, Brazil)
Dare Owatemi (University of Strathclyde, United Kingdom)
This paper embeds real options in an investment game of incomplete information in a duopolistic market, where product market competition influences the state value of the investment, and entry times are endogenously determined. The model incorporates private information over types and unveils new features of strategic interactions in imperfectly competitive markets when firms are faced with the trade-off between commitment and flexibility under demand uncertainty. The paper illustrates that type-asymmetry and/or initial demand level alone, as have been previously adopted in the literature, are insufficient criteria upon which endogenous roles under uncertainty may be determined when firms have private information over their types. Rather, the ex post market structure is determined by threshold functions whose images lie in the type-space of the firms. These functions, therefore, specify, ex ante, the firms' optimal strategies, which may involve (anti)-coordination. The model is extended to consider the plausible case where a firm is able to credibly "fool" its rival by masking its type. The threshold functions, and thus, ex post market structures obtained in equilibrium are found to be characteristically the same as with when types are truthfully revealed. Therefore, the competitive behaviour of firms remain the same whether or not there are industry regulations that make it illegal for firms to falsify, mask, or lie about their profits.
Cedric Justin (Georgia Institute of Technology, United States)
Dimitri Mavris (Georgia Institute of Technology, United States)
Commercial aircraft developments are major endeavors which strain considerably the resources of original equipment manufacturers. Beyond these financial strains, the development programs represent huge bets for the companies due to the fixed assumptions made when business plans are conceived and the abundance of uncertainties both at the technical and market levels. The long development cycles and the long lives of the assets once in operations force aircraft manufacturers to speculate regarding future airlines needs and future state of the world. One way of mitigating these risks is through a continuous optimization of the aircraft after it has entered service. These developments help manufacturers stretch the operating lives of their designs by keeping them up-to-date and therefore relevant in a changing competitive environment. Performance improvement packages represent a way for aircraft manufacturers to offer airlines the ability to infuse new technologies into existing aircraft at a minimum capital expenditure. Still, standard methods used for capital budgeting are not well suited to account for uncertainty and fail to capture the dynamic nature of markets and the erosion of leadership positions over time. The on-going research tries to overcome some of these challenges by proposing a real option based method to help substantiate aircraft development strategies. A method is proposed to carry out the valuation of strategies while accounting for some of the challenges identified. The analysis is applied to a performance improvement package for a commercial aircraft. Finally, the method is applied and some results are presented.
Georg Siegert (HHL Leipzig Graduate School of Economics, Germany)
Renewable energy subsidies in the form of feed-in tariffs implicitly give investors the possibility to shut down their renewable power plants temporarily or permanently. This real option is especially valuable for electricity from biomass, an important pillar of European renewable energy goals. The shut-down option is similar to a put on agricultural commodity prices, while the costs and benefits to the public are similar to underwriting a binary put. We apply our results to biogas plants subsidized by Germany's renewable energy policies and find that the option's share in investment value is sizeable, while costs and benefits to the public are much lower than would be assessed by DCF measures, but benefits decrease more. Simulations using the historic measure P show that there is a high likelihood that biogas will not contribute to a stable electricity supply or political goals of the share of renewable power sources. We derive suggestions for an improved feed-in legislation for electricity from biomass.
5:00 Delivery of Best Student Paper Award & Conference Participation Certificates
Closing Remarks / Conference Concludes