Day 1 – Thursday June 21
8:45-8:55 President’s Welcome
9:00-10:15 Track I (Managerial)
Chairperson: Luiz E. Brandao (PUC-Rio, Brazil)
Economic Resilience: Understanding the Dynamics of Deforestation in Laos
Transforming economic systems requires new investments and involves new uncertainties that can prevent change in poor agricultural communities. Using the illustration of deforestation in Laos, this paper demonstrates how a new framework for economic resilience can be used to understand the biophysical and institutional factors that affect deforestation and the potential for policies to transform poor agricultural communities. Deforestation in Laos is an important problem. Although Laos is one of the most biodiverse and forested countries in SE Asia, it has experienced significant deforestation during the second half of the twentieth century due to the growth of subsistence slash-and-burn agricultural practices. In response, the Lao Government has been attempting to curtail deforestation by promoting the transformation of agricultural communities away from these shifting practices towards sedentary forms of agriculture. This paper shows how recent developments in the application of real options analysis to questions of optimal timing can be used to more clearly define and measure the concept of economic resilience in this context. This approach can be used to measure and value economic resilience in terms of the expected time to decision thresholds and to analyse the effect of common policy levers on the economic resilience of shifting agriculture.
Energy Certificate (REN) based Digital Coin Offers
The reduction of pollution and greenhouse gas emissions have been the focus of major global effort (Lellis, 2007). In this context, the Renewable Energy Certificate (REC) are of great importance to promote changes in the energy matrix, aiming at the adoption of clean and sustainable practices. Given the growth of this market over the years, a key driver for continued maintenance and expansion of the adoption of RECs falls on a new disruptive and fast-reaching global technology such as digital currencies. Viewed as an opportunity to reduce bureaucracy, increase transparency, reduce costs and ease of access, a new group of coins for sustainable energy area already available in the digital market, such as Solarcoin, Energycoin and Carboncoin. Nonetheless, models that protect investors from speculation in this sustainability-based and REC-based market are still scarce. This paper proposes a model to control and issue REC based digital coins under an equilibrium model with an option to defer issuance of the coins according to market demand. We apply this model to a hypothetical case and arrive at a positive NPV for this project considering the parameters adopted. This work contributes to understanding the dynamics of digital product performance under flexibility.
Under Uncertainty: Ethanol Plants and Biofuels Mandates
The value of a representative ethanol producer, that benefits from both low and high gasoline prices in the short-run, is modeled. Ethanol producers make a modest competitive profit in the mandate-induced region of production. A low price of gasoline increases the demand for blend ethanol and consequently increases the profit of ethanol producers. On the other hand, when gasoline becomes costlier than ethanol, the capacity constraints of the biofuels sector bind and ethanol producers gain large quasi-monopoly margins. This is an interesting example of a market where two commodities are complement up to a point and then substitute after that. We postulate the value of an ethanol producer as a strangle option consisting of two real options: the option to substitute gasoline at times of expensive crude oil and the option to expand supply of blend at times of cheap gasoline. Using a dynamic model we show that the higher volatilities of crude oil and ethanol costs increase biofuels firms' value. We also find non-monotonic relationships between the value of an ethanol plant and several underlying variables, including gasoline price level. We estimate the value provided by a 10% blend mandate to be around $150,000,000 for a representative ethanol unit. Our results offer a novel view of oil and feedstock price risks in contrast to the common belief that considers those risks as a negative factor for the biofuels sector.
9:00 – 10:15 Track II (Academic & Managerial)
Chairperson: Lenos Trigeorgis (U. of Cyprus & King’s College London)
Option: Application to BP's Deepwater Horizon Case
Discussant: Hernandes Fagundes, State University of Northern Rio de Janeiro
Sustainability is a strategy that impacts project value estimation. The aim of this study is to present a model based on a Real Option approach which introduces Sustainability in project evaluation using the “Real Option for Sustainability”. From the purpose of this paper, Sustainability means to invest in mitigating environmental, social and governance (hereinafter ESG) risks. Therefore, we find that under our model, sustainable projects present also an actual value resulting in the mitigation of their ESG risks. This evaluation is useful for helping Management to take decisions and for all the stakeholders because it provides further elements when considering projects’ capability of generating value over time. This paper is structured as follows: firstly, we present the Sustainability topic and secondly, we propose a Real Option methodology for sustainable strategies’ evaluation and a related illustrative case study based on the British Petroleum's management decisions that caused the Deepwater Horizon disaster (on 20th April 2010).
Options Evaluation and Decision-making in Petroleum Exploration and Production
Discussant: Miriam Pedol, Assicurazioni Generali S.p.A.
This study establishes a risk-neutral binomial lattice method to apply real options theory to valuation and decision-making in the petroleum exploration and production (E&P) industry under uncertain oil prices. Options theory is applied to the switching time from primary to enhanced (water flooding) oil recovery. First, West Texas Intermediate (WTI) oil price evolution in the past 25 years, from January 2, 1986 to May 28, 2010, is studied and modeled with geometric Brownian motion (GBM) and one-factor mean reversion price models. Second, production profile for primary and water flooding oil recovery for a synthetic onshore oil reservoir is generated using UTCHEM simulator. Third, the binomial lattice real options evaluation (ROE) method is established to value the project with flexibility in switching time from primary to water flooding oil recovery. Seven results and conclusions are reached: 1) for GBM price model, the assumptions of constant drift rate and volatility do not hold for WTI oil prices; 2) one-factor mean reversion model is better to fit WTI oil prices than GBM model; 3) the evolution of WTI oil prices in the past 25 years was according to three price regimes and since 2003, the world economy has increased its tolerance to higher oil prices and to higher price fluctuation from its long run price; 4) the established ROE method can be used to identify the best time to switch from primary to water flooding oil recovery; 5) with one-factor mean reversion oil price model and the most updated cost data, the ROE method finds that water flooding switching time is earlier than that from traditional net present value optimizing method; 6) the ROE results reveal that most of time water flooding should start when oil prices are high; and 7) water flooding switching time is sensitive to oil price models and to the investment and operating costs. The established ROE framework enhances the valuation and decision-making for petroleum E&P industry including when to switch from one enhanced oil recovery method to another and when to switch from conventional to unconventional hydrocarbon production.
Flexibility for Oil Well Construction Services
Discussant: Betty Simkins, Oklahoma State University
The antagonism between long term commitments and a highly uncertain scenario is notorious, however no few decisions are made in such conditions. Focusing on features connected to offshore subsea and well services, we search for value maximization adopting a flexible business model, where the contractor has the right to increase service level during the agreement period. The paper develops a practical and applied approach, modelling uncertainty as a mean reverting stochastic process and valuing decisions flexibility through real options theory and Cox-Ross-Rubinstein discrete method. The options consideration improved contract value and provided decision guidelines that can help managers to accomplish better dealings.
10:15 – 10:45 Morning Coffee Break
9:00 – 10:15 Track I (Managerial)
Chairperson: Yuri Lawryshyn (U. of Toronto, Canada)
for the Rio de Janeiro International Airport: A Case of Option Overvaluation?
In May 2013, the Brazilian Federal Government, through the National Civil Aviation Agency (ANAC), announced the intention to bid a 25-year contract to expand, maintain and explore the Rio de Janeiro International Airport (Galeão). The contract was awarded to the RIOgaleão consortium which offered a bid that was four times the value of the US$ 2.2 billion minimum bid. Since the traditional DCF valuation of the concession which also showed a much lower value for the project was made public at the time of the auction, we analyze whether the concession had managerial options that could account for this difference. In fact, given that this is one of the few airports in Brazil that is both close to a major city and yet still has significant expansion options, we analyze whether the value of these options may be the reason for this high bid. We model the concession under the real options approach, considering that the concession can flexibly expand its operations in response to a surge in passenger demand. Our results suggest that the project value is close to the minimum bid value established by the government, and the value of the expansion options are insufficient to justify the high bid value presented by the RIOgaleão consortium. This indicates that the consortium may have significantly overpriced their bid.
Options in Road Infrastructure Concessional Delivery: A Case Study in Vietnam
Concessional delivery, encompassing public-private partnerships (PPP, P3), privately-financed initiatives (PFI, PFP), and build-own-operate-transfer (BOOT), are promoted widely in the development of public infrastructure. Within such delivery, a subsidy or guarantee from the relevant public sector authority might be necessary in order to mitigate the revenue-based risk of the private sector concessionaire. Revenue here refers to tolls collected. This could be expressed as the public sector authority contributing to the concessionaire’s revenue when revenue falls below a pre-agreed (lower) level. In return, the public sector authority could request a simultaneous upper level guarantee on revenue received by the concessionaire. Together, the lower and upper levels define a finite bandwidth of revenue. The financial value of the arrangement can be evaluated as bound options, involving yearly options over the PPP concession period. The arrangement offers fairness over one-sided (upper or lower guarantee levels) protection, such as either minimum or maximum revenue guarantees. The paper looks at the benefits, drawbacks and applicability of bound options in infrastructure road projects. It demonstrates the calculation of the option values via a probabilistic cash flow approach. It is shown that this approach offers a ready method to evaluate options, including the selection of the bandwidth, requires minimal financial and mathematical knowledge, and hence offers a practical and fair way forward to the implementation of concessionally-delivered projects.
Valuation of a Geothermal Power Project: A Case Study in Indonesia
The energy sector contributes 41 percent of total greenhouse gas (GHG) emission, which one of the options to reduce GHG emission from this sector is the deployment of renewable energy. Geothermal, as a renewable energy source, could support the decarbonising of the power sector. Currently, the option values are not adequately reflected in the way geothermal are appraised. A real options framework may provide a comprehensive analysis of options relating to the exploration. The result shows that there is a significant yielding value for the project. The options value for the geothermal project provided a substantial basis for investors to involve in this renewable energy development. A broader application of the real options may steer the geothermal energy development investment that may contribute to the cleaner energy sector.
10:45-12:00 Track II (Academic & Managerial)
VC, Technology & Health
Chairperson: Kuno Huisman (Tilburg U., Netherlands)
Options in the Health Sector
Discussant: Baran Siyahhan, Telecom School of Management
The Real Options Theory, commonly used to evaluate investment in situations of uncertainty, had its origin after the analogy made by Myers (1977). After Myers (1977), the number of papers about real options grew and its application in several sectors has been observed, but in the health sector, the studies on Real Option Theory - ROT started in 1996. With the focus in to identify the evolution of the studies in the health sector, the present article presents a bibliometric study that aims to analyze the studies published in the main scientific bases, observing the aspects related to authors, year of publication, the objective of the study, object analyzed and study cited. To analyze the data it was used the descriptive statistics. The main conclusion it is that the application of ROT in the health sector is not only in the evaluation of investment or scenarios, but also has been observed its applicability in medical decision making.
Investments in Digital Business Transformation
Discussant: Milena Rocha, Federal University of Minas Gerais
Emerging digital technologies represent major challenges for established corporations around the world. To succeed in this rapidly changing environment, it is no longer sufficient to compete by incremental product innovations. Achieving sustainable competitive advantage requires managers to exploit the disruptive potential of technology by transforming business models, value chains or entire markets. Digital Business Transformation (DBT) is defined as a significant change in an established company’s business model driven by digital technology. It is a necessary tool to adapt business models in the rapidly changing business environment. In this context, managers are facing the challenging task of finding the right investment decisions. Standard project valuation models such as the Net Present Value (NPV) method do not capture managerial flexibility, which is particularly valuable in risky Digital Business Transformation projects. In this context, Real Option Analysis can be applied as a sophisticated alternative for investment decision making. So far, no research has been conducted on the interface between DBT and Real Options Theory. In this paper, we present our approach to valuing the option to expand from a trial project into a large-scaled transformation project by including the business-related uncertainty surrounding DBT and show that this option has the potential to shift traditional investment decisions. This paper is aiming to highlight the importance of this area, develop simple methods to cope with it and lay the foundations for future research.
Venture Capital (CVC) Investments and Acquisition Decisions
Discussant: Robin Schneider, Keio University
This paper studies the optimal timing of corporate venture capital investments and subsequent acquisition decisions under technological uncertainty. We consider a large firm interested in a technology being developed by a start-up. The firm has the option of investing in the startup at an early R&D stage through a CVC, or to wait until the technology is mature before acquiring it. While an early CVC allows the firm to start integrating the new technology, it induces the risk of losing the premium if the technology does not develop as expected. We formulate the problem as a real option problem where the firm aims at maximizing its profit att= 0, considering possible CVC and acquisition decisions in the future. We solve the problem using a two-level dynamic programming algorithm and show the optimal firm decision.
12:00 – 2:00 Luncheon
2:00 – 3:15 Track I (Managerial)
Chairperson: Verena Hagspiel (NTNU, Norway)
Hydropower Generation Risk
The variability of river inflows impact the energy production of hydropower generators and may result in reductions in revenues that can be financially disruptive. Uncertainty about future hydrological risk suggest that hydropower generators must begin to consider new risk mitigation mechanisms. In this article we propose the use of swaps, collars and collar by difference, to mitigate this risk. Contract structures are then evaluated using simulations that describe hydropower operations in the Brazilian rivers. In all three cases, the contracts are shown to be capable of substantially reducing the risks of very low revenue periods. In addition, our models outperform the results of the traditional commercial hedge.
a Gold Mining Project with Multiple Uncertainties
Metal price, exchange rate, and operating costs are three of the most important sources of uncertainty in mining projects. In that sense, numerous research studies have been carried out to account for price uncertainty, while few others have incorporated the simultaneous effects of operating costs and price uncertainties. However, there is no outstanding research on the simultaneous impact of the three sources mention before. Based on this, the purpose of this paper is to introduce the octanomial tree method to value an Australian gold mine project by adding three market’s uncertainties such as the gold spot price, USD/AUD exchange rate and the operational costs, under a multidimensional binomial tree approach. The proposed model combines the simplicity of the binomial tree with the ability to deal efficiently with multiple uncertainties.
Investment under Policy Uncertainty and Bayesian Learning
Many countries have introduced support schemes to accelerate investments in renewable energy (RE). Experience shows that, over time, retraction or revision of support schemes become more likely. Investors in RE are greatly affected by the risk of such subsidy changes. This paper examines how investment behavior is affected by updating a subjective belief on the timing of a subsidy revision, incorporating Bayesian learning into a real options modeling approach. We analyze a scenario where a retroactive downward adjustment of fixed feed-in tariffs (FIT) is expected through a regime switching model. We find that investors are less likely to invest when the arrival rate of a policy change increases. Further, investors prefer a lower FIT with a long expected lifespan, while policy makers prefer a higher FIT with shorter life span. We also consider an extension where, after retraction, electricity is sold in a free market. We find that if policy uncertainty is high, an increase in the FIT will be less effective at accelerating investment. However, if policy risk is low, FIT schemes can significantly accelerate investment, even in highly volatile markets.
2:00-3:15 Track II (Academic & Managerial)
Investment & Valuation
Chairperson: Tarik Driouchi (King's College London, UK)
Option Value of Mortgage Interest Tax Deductibility
Discussant: Tarik Driouchi, King's College London
The tax shield value of the mortgage interest deductibility (MID) can be significantly lower than what it might seem when the tax code requires the household to switch from `standard' to `itemized' deductions. We define the effective tax deductible rate (ETDR) for different households. Our pay-off model identifies convexities and concavities in the relationship between the effective mortgage interest tax deduction and a set of the underlying variables including household income, house price, and local and state tax rates. To quantify the expected value of the MID, a dynamic option-pricing model is proposed and solved. The model is simulated for a range of realistic household characteristics. Using the quantitative model we compare the relative attractiveness of an Adjustable Rate Mortgage (ARM) versus a Fixed Rate Mortgage (FRM), and demonstrate an inverse U-shape relation between the tax shield of the two types of mortgages and the household income. We find several inverse-U relationships between the volatility of underlying variables and the present value of the MID. We then discuss the tenure and location choice implications of the model to analyze the impact of tax reforms on the ratio of rent to value for different classes of houses. Finally, we report empirical evidence in line with the predictions of our theoretical analysis. Finally, we report a critical analysis of the MID representation in a set of popular real estate advising websites.
Is the Brucellosis Vaccine Competition Prize Right? Innovative Financing for the
Discussant: Lenos Trigeorgis, U of Cyprus and King's College, London
The Brucellosis Vaccine Pilot project is a new $30 million financial instrument with the objective to incentivize the private sector to enter markets they might not prioritize, but which would have a large impact in the developing world. The Brucellosis Vaccine Pilot project is a multi-phase and very costly project, which is exposed to several risks, such as the failure during research and development of vaccines and sales of the vaccine that depends on the final demand of the vaccines. Traditional costs and benefits analysis for the evaluation of this kind of investment decisions is not sufficient. Real Options Analysis, however, is a suitable tool for the valuation of the Brucellosis Pilot project, since it can adequately deal with its characteristics, i.e. multi-phase and uncertainties. In this paper we present a sequential options model that provides insight into the costs and benefits for both the participants as well as the funders of the prize mechanism. Crucial with regards to this type of intervention is setting the prize right, which means to set it high enough to encourage private parties to participate, but still give them incentive to commercialize the vaccine at an affordable prize to the developing world.
Relevant Information Beyond Analysts’ Forecasts: Role of Growth Potential and
Discussant: Linda Peters, University of Antwerp
This paper explores the value relevant information beyond analysts’ forecasts in residual income dynamics and equity valuation. More specifically, we incorporate Growth Potential (GP) and Bankruptcy Risk (BK) into the residual income dynamics beyond analysts’ forecasts. Among the various proxies, we find the Present Value of Growth Potential (PVGO) of Kester (1984) and the Loss Given Default (LGD) of Merton (1974) best capture GP and BK effects. We demonstrate that GP and BK provide additional information content beyond lagged residual income and analysts’ forecasts in the residual income dynamics. Moreover, incorporating GP and BK in residual income dynamic beyond analysts’ forecasts reveals superiority in equity valuation in terms of forecast accuracy and explainability. The subsample analysis shows that the improvement of this model is mainly reflected in the high potential growth subsample and high financial risk subsample, in line with growth potential and bankruptcy risk theories.
3:15 – 3:45 Afternoon Coffee Break
3:45 – 4:30 Keynote Address by Arnd Huchzermeier (WHU)
4:30 – 5:30 Panel Discussion: State of Practice & Future Prospects
Moderator: Dean Paxson (U. of Manchester, UK)
5:30 – 7:00 Barbeque & Networking
Sponsored by ROG
Day 2 Friday June 22
9:00 – 10:15 Track I
Competition & Games
Chairperson: Peter Kort (Tilburg U., Netherlands)
of New Technologies in a Duopoly
Discussant: Elżbieta Rychłowska-Musiał, Poznań University of Economics and Business, Poland
We derive a multi-factor duopoly real option game model that is applied to the optimization of new technology adoptions, where there is uncertainty about market revenue, efficiency after adoption and technological progress. We obtain analytical solutions for the firms’ value functions and analytical/numerical investment thresholds for alternative investment scenarios. We find that positive changes in the probability of technological innovation sharply reduces the follower’s sensitivity to changes in the leader’s first-mover advantage and, somewhat surprisingly, that for moderately low “probability that a second technology arrives in the next instant”, market and technical uncertainty are no longer relevant factors determining the investment behaviour of rival firms.
in a Random-start American Option Under Competition
Discussant: Alcino Azevedo, Aston Business School
In this paper we develop a model to determine the value of the opportunity to invest in a random start American (real) option. In contrast to a typical American option, the random start option only exists if an exogenous event occurs materializing the (true) American option to invest. In addition, the effect of competition is also considered in the model. A higher risk of competition and a higher probability of the exogenous event promotes investment. Uncertainty has a non-monotonic effect on investment timing.
Value in Real Option Games Among Asymmetric Firms
Discussant: Artur Rodrigues, University of Minho
To make an investment decision based on the classic real options approach, the value of an investment option should be compared with the benefits of an instantaneous investment. However, if the investment option is a shared one, a firm should take into account how its decision influences its competitor decision, and how it itself may be impacted by rival’s reactions. Therefore, firms’ strategic choices could be described as a (non-zero sum) real options game. We present a general model of real options games for two (asymmetric) firms operating in the competitive market. The main goals and the unique contribution of this paper are to find when the game between competitors is a bargaining game type and to consider the Nash bargaining solution and the cooperative-competitive value (coco value) as a solution of a real options bargaining game between competitors. We try to specify the optimal recommendation for firms in each bargaining case and to check whether both parties will always be consistent in choosing the solution approach. Sensitivity of the firm’s strategy profile, the Nash bargaining solution and the coco value to the changes in the important variables (especially project risk) are also provided. These considerations lead to interesting conclusions, especially for companies that dominate the market.
9:00-10:15 Track II
Modeling & Estimation
Chairperson: Chairperson: Gordon Sick (U. of Calgary, Canada)
General Two-Factor Investment Model: Option Value and Partial Derivatives
Discussant: Yuri Lawryshyn, University of Toronto
We provide simplified solutions for determining the real option value (and exercise threshold) for a perpetual opportunity to invest when there are two stochastic factors and circumstances which do not allow dimensionality reduction. Our solution is easy to compute, amenable to interpretation, and enables analytical derivations for the partial derivatives. We compare the properties of our model with one-factor and two-factor homogeneity degree models. Analytical and numerical illustrations show that some of the typical real option value and thresholds assumptions, such as positive “vegas” do not necessarily hold.
Price Forecasts, Futures Prices and Pricing Models
Discussant: Roger Adkins, University of Bradford
Even though commodity-pricing models have been successful in fitting the term structure of futures prices and its dynamics, they do not generate accurate true distributions of spot prices. This paper develops a new approach to calibrate these models using not only observations of oil futures prices, but also analysts´ forecasts of oil spot prices. We conclude that to obtain reasonable expected spot curves, analysts´ forecasts should be used, either alone or jointly with futures data. The use of both futures and forecasts, instead of using only forecasts, generates expected spot curves that do not differ considerably in the short/medium term, but long term estimations are significantly different. The inclusion of analysts´ forecasts, in addition to futures, instead of only futures prices, does not alter significantly the short/medium part of the futures curve, but does have a significant effect on long-term futures estimations.
Option Valuation Using Simulation and Exercise Boundary Fitting
Discussant: Gonzalo Cortazar, Pontificia Universidad Catolica de Chile
The focus of this research is the development of a real options valuation methodology geared towards practical use. A key innovation of the methodology to be presented is the idea of fitting optimal decision making boundaries to optimize the expected value, based on Monte Carlo simulated stochastic processes that represent important uncertain factors. We show how the methodology can be used to value a simple Bermudan put option and discuss convergence and accuracy issues. Then, we apply the methodology to a real options build / abandon problem for a single stochastic factor.
10:15 – 10:45 Morning Coffee Break
10:45 – 12:00 Track I
Infrastructure & Capacity Investment
Chairperson: Paulo Pereira (U. of Porto, Portugal)
Investment and Volume Flexibility under Uncertainty
Discussant: Matteo Balliauw, University of Antwerp
Real option theory is a central tool in today's investment theory as it integrates uncertainty and managerial flexibility in the analysis and valuation of investment projects. This paper studies the optimal time and size of investment for a monopolistic firm under demand uncertainty and volume flexibility. In our modeling framework, demand is random and the firm first decides the optimal time and size of the production process. After entry, the firm adjusts continuously production volume to match the observed demand. Volume flexibility comes at a cost which depends on both the current output and the established capacity. We study two different models of volume flexibility: Downside volume flexibility allows the firms to produce any quantity below the installed capacity. Upside volume flexibility also allows to expand production above the firm's capacity size. In both cases, the option to temporary suspend production is not given a priori, but it is part of the firm's optimal choice. With this feature, the model provides conclusions that contrast some of the most recent theoretical findings on the same subject. We find that an increase of the degree of downside volume flexibility makes the firm willing to invest earlier in a larger plant. We also show that downside volume flexibility reduces the utilization rates, especially in highly uncertain markets. Upside volume flexibility has the joint effect of reducing the size of the investment and the investment threshold at which the firm installs capacity. The utilization rates are significantly higher compared to the case of downside volume flexibility only, and there is an increasing relationship between increased upside flexibility and utilization rates.
Problems in PPP Investment Projects
Discussant: Domenico De Giovanni, Department of Economics, Statistics and Finance "Giovanni Anania" - University of Calabria
This paper examines investment timing by a private firm in a public-private partnership with a government in the presence of agency conflicts arising from asymmetric information. The design of optimal contracts to provide incentives to the private firm to exert effort is analyzed. We show within a real options framework that although first-best investment timing can be implemented, this comes at the cost of a social welfare loss. The analysis is extended to incorporate an exit/bailout option for the private firm.
Port Capacity Investment Decisions under Congestion and Uncertainty
Discussant: Florina Silaghi, Universitat Autonoma de Barcelona
Port capacity investments involve large projects with high uncertainty and irreversibility. In a landlord port, the managing port authority (PA) is responsible for the investment in infrastructure on the one hand. On the other hand, the terminal operating company (TOC) that obtained a concession from the PA to handle the cargo, invests in the superstructure. Moreover, the PA is often partly or fully publicly owned, leading to the inclusion of social welfare among its objectives. Because port users are averse to congestion and the costs it involves, the investment decision is complexer in this service environment than in a production environment. In this paper, the optimal size and timing of a new capacity investment in a public landlord port is studied using a real options approach. Compared to the findings in a similar service port fully managed and operated by only one actor, it is found that the PA can follow the strategy of forcing the TOC to invest in the PA's individual optimum. If the destruction of aggregated welfare is to be avoided, the PA and TOC could agree to invest at the optimum of a service ports' single actor and redistribute the additional gains. As opposed to a common real options finding, higher public involvement leads to a larger investment that is also made earlier.
10:45-12:00 Track II
(Dis-) Investment, Timing & Risk
Chairperson: Elizabeth Whalley (U. of Warwick, UK)
Delisting Timing: Real Option Theory and Empirical Evidence
Discussant: Kyoung Jin Choi, University of Calgary
We develop a real options model which determines the optimal delisting time and provide a sensitivity analysis regarding the effect of the model parameters on our results. We test our results empirically using a data sample that comprises information on 2,577 US firms, of which 219 were delisted voluntarily over the time period between 1980 and 2016. Specifically, we estimate the probability of voluntary delisting using a survival analysis and find that both access to capital and financial visibility are good predictors for the delisting decision. Our empirical evidence also supports the asymmetric information hypothesis. We do not find conclusive empirical evidence suggesting that the stock liquidity affects the optimal voluntary delisting time.
the Sign (of Exposure) Matters: Real Options, Abatement and Risk Aversion
Discussant: Alcino Azevedo, Aston University
We show that risk aversion has opposite effects on investment thresholds depending on the sign of the underlying risk exposure. Investments which increase exposure to a risky revenue-type variable are delayed, but investments which decrease exposure to a risky cost, such as overseas production operations, energy costs for energy-intensive production processes or abatement investments in the face of potential future stochastic carbon prices, are brought forward, even if the incremental cash-flows are identical. Risk aversion also increases the attractiveness of splitting investments into multiple stages. Investment thresholds are affected by the incremental change in risk exposure, which is non-linear, so all a firm's real options should be valued as a whole. We illustrate the errors which can arise from ignoring this.
Horizon and Idiosyncratic Risk
Discussant: Elizabeth Whalley, University of Warwick
We consider a decision maker’s problem in a real option framework with several projects that can only be sequentially undertaken within a “decision horizon” and characterize the optimal sequence of exercises. We show that the length of the decision horizon, time until projects’ expiration, directly affects the order of execution of the projects and the risk exposures of the firm. Limited decision horizon is a time constraint that leads to early executions of projects with high idiosyncratic volatility. Consequently, the decision maker’s current value is lower and more volatile than when he faces an ample decision horizon. We empirically document that firms with a short (long) decision horizon are associated with high (low) idiosyncratic volatility. We also verify that this relationship depends on the decision makers’ exposure to idiosyncratic risk and is stronger for firms more heavily dependent on real option projects. Our paper opens a new perspective on firm investment theory and advocates for more research on the determinants and effects of the decision horizon.
12:00 – 2:00 Luncheon
2:00 – 3:15 Track I
Debt & Capital Structure
Chairperson: Gordon Sick (U. of Calgary, Canada)
Debt Financing and Investment Timing with Heterogeneous Beliefs
Discussant: Peter Kort, Tilburg University
We develop a real options model for a firm borrowing using a loan commitment and derive the optimal timing of investment and optimal capital structure in the presence of heterogeneous beliefs about the volatility of assets between debt and equity holders, equity financing costs and loan commitment fees. We show that unfavorable beliefs from debt holders about the volatility causes a delay in investment, higher credit spreads and a decrease in debt capacity and the option value to invest. On the positive side, unfavorable debt holders’ beliefs reduce the agency costs between debt and equity holders associated with the timing of investment. High equity investment financing costs result in an increase in credit spreads and agency costs, while high loan commitment fees accelerate investment, however, they reduce debt financing and result in larger agency costs. We also present a multi-stage model with partial drawdowns and provide implications relating to the effect of expected time to new investments on commitment levels and fees.
Options and Performance-Sensitive Debt
Discussant: Nicos Koussis, Frederick University
We consider a situation where a firm can decide when and by how much to expand its production scale (“option to expand capacity”). In contrast to the standard model, we allow for an endogenous choice of size. We consider the interplay between the capacity expansion and the shareholders' defaulting strategy in case of performance-sensitive debt
Structure Choice and Investment Timing
Discussant: Benoit Chavalier-Roignant, King's College London
The paper considers the problem of an investor that has the option to acquire a firm. Initially this firm is run as to maximize shareholder value, where the shareholders are risk averse. To do so it has to decide each time on investment and dividend levels. The firm's capital stock can be financed by equity and debt, where less solvable firms pay a higher interest rate on debt. Revenue is stochastic. We find that the firm is run such that capital stock and dividends develop in a fixed proportion to the equity. In particular, it turns out that more dividends are paid if the economic environment is more uncertain. We also derive an explicit expression for the threshold value of the equity above which it is optimal for the investor to acquire the firm. This threshold increases in the level of uncertainty reflecting the value of waiting that uncertainty generates.
2:00-3:15 Track II
Uncertainty & Ambiguity
Chairperson: Motoh Tsujimura (Doshisha U., Japan)
Effects of Exogenous and Endogenous Uncertainty on a Joint Venture
Discussant: Motoh Tsujimura, Doshisha University
This study employs a stochastic model to investigate how uncertainty of different types (i.e., exogenous and endogenous) affects the value of a joint venture (JV). The model examines three scenarios. The results demonstrate that endogenous uncertainty is a necessary condition for a JV to have any option value embedded, refusing the argument that JV partners only respond to exogenous uncertainty but not to endogenous uncertainty.
Real Assets: Idiosyncratic Project Risk in an Uncertain Auction Environment
Discussant: Tailan Chi, University of Kansas
Consider a seller auctioning a real asset among n agents. Each agent contemplates a specific investment project and the asset is crucial for its activation. Project cash flows and their volatility are private information. We determine the optimal bid function and show that the auction is efficient. The asset is assigned to the project characterised by the highest volatility in the associated cash flows. Interestingly, the bid does not depend on the investment time or on the changes in post-auction cash flows. We also address concerns about the distribution of the project value among the parties. Finally, we show that cash flow volatility has an ambiguous effect on losses due to the information failure.
Investment under Demand Ambiguity
Discussant: Luca Di Corato, Dipartimento Jonico, UniBA
This paper investigates a firm's partially reversible capital investment problem when output demand is ambiguous. We adopt the Choquet--Brownian motion process to incorporate the ambiguity of demand. To solve the firm's problem, we formulate it as a singular stochastic control problem. Then, we use variational inequalities and derive the optimal investment strategy. It is described by two thresholds that respectively determine the capital expansion and reduction. Furthermore, we obtain useful insights for the firm's investment decision-making through a comparative static analysis. We find that higher volatility and ambiguity aversion discourage capital investment.
3:15 – 3:45 Afternoon Coffee Break
3:45 – 5:00 Track I
Modeling & Computation
Chairperson: Tailan Chi (U. of Kansas, USA)
Do Solutions for Two Factor Real Options Models Compare?
Discussant: Elmar Lukas, Faculty of Economics and Management, University Magdeburg
We compare three types of "analytical solutions" suggested for some two-factor real option models: dimension reducing techniques, and similarity arguments; quasi-analytical solutions, where the PDE function factors are not homogeneous of degree one; and for some similar conditions, the quadratic analytical solutions as in Heydari (2010) and Store et al. (2017. These might be characterized as first, second and third generation models, appearing almost sequentially in time. Comparisons are based on how the differential equations are solved, the possibility of a unique solution, the level of realism, and the ease and transparency of obtaining partial derivatives.
Enhancing Pre-investment Activities under Uncertainty
Discussant: Dean Paxson, AMBS
Real options models of investment mostly concern the firm's stochastic environment as exogenously given and subject to constant parameters. We consider a firm that can sequentially invest to alter the growth rate of a project's revenues through a value-enhancing pre-investment activity, both when the change is fixed, and when the magnitude of the change can be optimally chosen by the firm, before entering the market. We find that this incentivises the firm to invest sequentially, first in revenue-enhancing activities and then to enter the market some later time. This is in contrast to the two-stage investment problem in Dixit & Pindyck (1994), wherein it is never optimal for the firm to invest sequentially. There is both an option value of waiting that delays investment in value-enhancing activities, as well as an accelerating effect from the change in growth rate, which increases the value of the project. Thus, the resulting effect of uncertainty is not straightforward, as increasing uncertainty can both delay or expedite the investment in revenue-enhancing activities, dependent on the cost parameters and the magnitude of the change in the growth rate. When the firm can optimally choose the amount of the value-enhancing activity, we find that the firm invests more in these activities when uncertainty is higher. When the marginal cost of the activity increases, the firm undertakes less revenue-enhancement, but the overall amount spent increases.
Dynamic Games under the Threat of Hostile Takeovers
Discussant: Tord Olsen, Norwegian University of Science and Technology
This paper builds on recent advances in the domain of option games under uncertainty and looks closer at determinants that drive friendly mergers. Each firm calculates its payoff resulting from either a friendly merger or hostile takeover that then serves as a credible threat when jointly negotiating the terms of a merger. In contrast to similar papers, we show that the firms still have an incentive to delay the merger. Moreover, the results indicate that threat values are important for the asymmetric firm case, i.e. when firms have different bargaining power. The weaker firm can improve its position in the merger as uncertainty increases, i.e. its share in the new entity increases. The same holds true if synergies increase.
3:45 – 5:00 Track II
Supply Chains & Contracts
Chairperson: Arnd Huchzermeier (WHU, Germany)
Chains, Investments with Vertical Relations and Agency Conflicts
Discussant: Artur Rodrigues, University of Minho
We examine the case of an investment project that, i) is characterized by uncertainty and irreversibility, ii) is undertaken in a decentralized setting and iii) its completion is conditional on the provision of an input by an outside supplier with market power. Our findings suggest that, if compared to a case where the input is insourced, the vertical relation increases the investment cost. Nevertheless, the effect on the timing and the value of the investment is ambiguous since it depends on the information endowment of the involved parties. We discuss three levels of information sharing among the links of the supply chain and we identify the cost, the timing and the value of the option to invest for each one of them.
Value of Renewable Identificaiton Numbers (RINs)
Discussant: Dimitrios Zormpas, University of Padova
We model the dynamics of equilibrium prices in the renewable identification number (RIN) market. Our modeling framework is different than the usual practice which prices RINs in a static model. Using a continuous-time stochastic control formulation, we explicitly model the option value inherent in the RINs prices as an American spread option, given the institutional constraints of the market. To this end, we utilize two different processes for the underlying prices, namely, geometric Brownian motion and geometric mean-reversion. The former enables deriving a closed-form solution of the price, and the latter allows for a numerical but yet more realistic approximation. Among other results, we show that the price of RINs has a positive relationship with the volatility of ethanol and crude oil prices and a negative relationship with the correlation between the two price processes. We also show that the choice of time-series model for gasoline and ethanol prices has a significant impact on the value of RINs. In particular, we solve the model for GBM and mean-reverting price processes and simulate both specifications using real-world calibrated parameters.
Tariff Contract Schemes in Oligopoly
Discussant: Gordon Sick, University of Calgary
This paper presents a model to analyze three different types of feed-in tariff (FIT) contracts within an oligopolistic market structure. The FIT contracts are the minimum price guarantee, the premium price and a fixed price. The derivation uses an asymmetric Stackelberg model and a real options valuation model with a perpetual and finite duration of the FIT contracts. With the model, we can find several interesting properties. First, we can identify the optimal time to deploy a renewable energy project. Second, we can analyze how the value and duration of a minimum price guarantee, a premium over the market price and a fixed price affect the investment threshold and the value of the project. The results show that a perpetual guarantee can only induce investment for prices below the minimum price guarantee, when the project compensates the investment cost. Another interesting result is that a FIT contract with a higher price and duration induces an earlier investment. We also compare the three FIT contracts with a social welfare analysis in order to shed some light on the effectiveness of the three policy schemes.
Day 3 – Saturday June 23
9:00 – 10:15 Track I
Switches, Runs, Caps & Collars
Chairperson: Dean Paxson (U. of Manchester, UK)
Estimation of Switching Costs for Peaking Power Plants
Discussant: Yishay Maoz, The Open University of Israel
This paper estimates costs associated with mothballing, restarting, abandoning and maintaining peaking power plants. The paper develops a real options model to explain switching and maintenance behavior of plant managers. The constrained optimization approach to estimate crucial costs accommodates non-parametric dynamics for the expectations of the plant managers regarding future profitability. The empirical analysis is based on a database of the annually reported status of power plants to the United States Energy Information Administration (EIA) during 2001-2009. We arrive at economically meaningful estimates of maintenance costs and switching costs, and discuss these in light of rates used in the Pennsylvania-New Jersey-Maryland capacity market.
Decisions with Finite-Lived Collars
Discussant: Stein-Erik Fleten, Norwegian University of Science and Technology
Most collar arrangements provided by governments to encourage early investment in infrastructure, renewable energy facilities, or other projects with social objectives are finite, not perpetual. We provide an analytical solution for finite American collars, subtracting from the value of a perpetual collar the discounted forward start collar. These perpetual and finite collars are composed of perpetual floors and ceilings, and floor and ceiling annuities, and pairs of put and call American options. What is the difference between perpetual and finite collars? Lots, including different vega signs, and substantially different values for different current price levels. A critical consideration in negotiating the floors/ceilings/duration of finite collars is the current price level and expected volatility over the life of the contract.
Imperfections and Competitive Runs under Uncertainty
Discussant: Paulo Pereira, University of Porto
In a market where production has adverse externalities, policy makers may wish to increase welfare by imposing a cap on quantity. Previous literature has shown that while this cap lowers the long run adverse effects of investment in that market, it also makes these adverse effects appear earlier, as the cap speeds-up investment to that market. The current article finds that among these two contradicting effects – the latter is the dominant, rendering the cap harmful for welfare. In particular, the cap speeds-up investment by creating a "competitive run" where all the investment still allowed is done at one instant.
9:00 – 10:15 Track II
Best Student Papers Session
Chairperson: Stein-Erik Fleten (NTNU, Norway)
IPO Valuation Premium "Puzzle" for an Entrepreneur’s Exit Choice
Discussant: Quentin Couanau, Université Paris 1
“IPO valuation premium puzzle” is an intriguing issue for the entrepreneurial exit strategy. This refers to a situation where many private firms choose to be acquired rather than to go public at higher valuations by the market participants. The objective of this paper is to explain this “puzzle” from the viewpoint of the interaction between an entrepreneur and a venture capitalist. The theoretical analysis of the “private benefits of control” (Bayar and Chemmanur, 2011, 2012) with the game theoretic real options approach shows that the “puzzle” is not really a puzzle. In addition, a new exit choice criterion is provided. The results of the numerical simulation show that even when the start-up business is highly evaluated by the market, acquisition and IPO is indifferent. This also suggests that the “puzzle” is not really a puzzle.
of Policy Withdrawal on Investment Timing and Size
Discussant: Yasuharu Imai, Normandy University
This paper analyzes the effect of a possible withdrawal of a tax credit policy on investment timing and investment size, and the interaction between investment timing and investment size. If the policy maker can only withdraw a policy once and not enact it in the future, we find that increasing the probability of withdrawal of a tax credit policy, increases the incentive to invest now and decreases the optimal investment size. Huisman and Kort  show that investing later means that the investor invests at a larger capacity, which is confirmed in this paper. It is found that a firm that invests at the timing threshold value invests at larger scale when the policy is not in effect than when it is in effect. This results from the fact that subsidy speeds up investment and earlier investment is done at a lower capacity. Unlike the price premium in Chronopoulos et al. , these conclusions do not hold only for low withdrawal probabilities, but for all withdrawal probability values, as the tax credit policy is only relevant at the time of investment. Therefore, increasing the withdrawal probability to a large value speeds up investment more. When the investor is a social planner who aims to the maximize social welfare, it is found that the social planner has the same timing as the profit-maximizing monopolist, but invests at twice the investment size. The monopolist seems to keep the price up by producing less.
Stopping and Real Options under Volatility Ambiguity
Discussant: Roel Nagy, Norwegian University of Science & Technology
This paper studies an optimal stopping problem with an ambiguity aversedecision-maker who perceives ambiguously the volatility of the underlying process. Ambiguous volatility is modeled by a set of nondominated probability measures and the analysis requires significant departure from the standard theory. We use recent advances in nonlinear expectation theory to characterize the optimal stopping time of a general optimal stopping problem and to reduce this problem to a free-boundary problem, analogous to the standard case. We then apply these results to the canonical irreversible investment model and to the perpetual American Call. We show that an increase in ambiguity accelerates investment, contrary to the well-known result that uncertainty delays investment. This result is also in stark contrast with previous work on drift ambiguity.
10:15 – 11:00 Morning Coffee Break
11:00 – 12:00 Panel: State of Theory & Future Prospects
Moderator: Gordon Sick (U. of Calgary, Canada)
Stein-Erik Fleten (NTNU, Norway)
12:00 Best Student Paper Award & Closing Remarks