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Annual International Conference on Real Options: Theory Meets Practice

Academic Program

Thursday June 28, 2012

8:00 - 8:30 Registration

8:30 - 8:45 Welcome

8:45 - 9:15 President's Address

Valuing Brand Leveraging Strategies
Lenos Trigeorgis (University of Cyprus, London Business School, and President, Real Options Group), with Francesco Baldi, LUISS University, Rome

9:15 - 10:15 Market Valuation & Empirical Evidence

Uncertain Climate Policy Decisions and Investment Timing: Evidence from Small Hydropower Plants
Kristin Linnerud (CICERO, Norway)
Ane Marte Heggedal (NTNU, Norway)
Stein-Erik Fleten (NTNU, Norway)
   Based on panel data of 214 licenses to construct small hydropower plants, we examine whether uncertainty with respect to the introduction of a market for renewable energy certificates affected the timing of investments in Norway from 2001 to 2010. Using regression analysis, we find that (1) investors owning a portfolio of licenses acted in accordance with a real options investment rule, and uncertain climate policy decisions delayed their investment rate; and (2) investors owning a single license acted in accordance with a traditional net present value investment rule, focusing on the value of the immediate investment and ignoring policy uncertainty.

Evidence on the Corporate Diversification-Value Puzzle
Pablo de Andrés (Autonomous University of Madrid, Spain)
Gabriel de la Fuente (University of Valladolid, Spain)
María del Pilar Velasco (University of Valladolid, Spain)
   We attempt to shed light on the diversification-value puzzle from the Real Options approach. Using a panel sample of U.S. firms from 1998 to 2010 and controlling for the potential sample self-selection, our results suggest that the first steps of this strategy mainly involve the replacement of prior acquired investment opportunities by assets-in-place until a breakpoint is reached when diversification turns into a source of investment opportunities for enterprises. We report evidence that diversification premiums/discounts are statistically related to growth options proxies and that the diversification strategy is more value-enhancing in those firms with a better set of growth opportunities.

Evidence on Revenue Rises vs. Cost Savings on Investors’ Valuation of Growth Options
Susana Alonso Bonis (University of Valladolid, Spain)
Valentín Azofra Palenzuela (University of Valladolid, Spain)
Gabriel De La Fuente Herrero (University of Valladolid, Spain)
   This paper analyzes the way investors consider growth options when pricing equity. We study the effect on stock prices of a case of acquisition of two different growth options. The case consists of two investment stages carried out in Enersis by Endesa in the 1990s. The effect of growth option values on investors’ expectations is analyzed from the abnormal returns in the period around the investment announcement. Our results show that a growth option which value comes from future rise in sales has a greater impact on stock returns than a growth option which value is based on cost savings.

10:45 - 12:00 Basic Methodological Issues

The Choice of Stochastic Process in Real Option Valuation
Luiz Ozorio (Ibmec, Brazil)
Carlos Bastian-Pinto (Unigranrio, Brazil)
Luiz Eduardo Brandao (PUC-Rio, Brazil)
   A main issue in valuation modeling is the correct choice of the stochastic process that better describes the asset price performance. Particularly, in investment projects that show a high level of managerial flexibility in conditions of uncertainty – for which it would be proposed the real option valuation models – the assumption of a specific process can have an impact not only on the project value, but also on the investment rule. This work discusses the choice of stochastic process in real options valuation and the main useful tests and theoretical considerations to give support to this task.

Are Results Consistent Among Different ROV Methodologies? A Copper Mine Application
Pietro Guj (Centre for Exploration Targeting, The University of Western Australia, Australia)
Atul Chandra (Centre for Exploration Targeting, Curtin University, Australia)
    There is controversy as to whether different ROV methodologies result in different real option values. Using a copper mining example it is demonstrated that if the same degree of subjectivity is used in the inputs of different ROV techniques, they will produce consistent results. This is valid irrespective of whether the cash flow volatility from market and private uncertainties is estimated in aggregate or separately for use in a decision tree. Two investment alternatives, to “buy now and develop” a copper mine or enter into a “two-year purchase option ” after the proponents have developed the project, are compared.

General Real Option Valuation with Application to Real Estate
Carol Alexander (ICMA Centre, Henley Business School, University of Reading, United Kingdom)
Xi Chen (ICMA Centre, Henley Business School, University of Reading, United Kingdom)
    The common paradigm for risk-neutral real-option pricing is a special case encompassed within our general framework. We analyse the relationship between standard real option prices and the more general risk-averse real option values, with fixed or stochastic investment costs. Numerical examples illustrate how these general values depend on the frequency of decision opportunities, the investor's risk tolerance and its sensitivity to wealth, his expected return and volatility of the underlying asset, and the price of the asset relative to initial wealth. Specific applications to real estate include property investment under `boom-bust' or mean-reverting price scenarios, and buy-to-let or land-development opportunities.

1:15 - 2:15 Basic Energy & Policy Applications

Clean Development, Stochastic Permit Prices and Energy Investments
David Schüller (University of Duisburg Essen, Germany)
Philipp Hieronymi (University of Illinois at Urbana-Champaign, United States)
    We evaluate the simultaneous impact of two emission permit classes with stochastically evolving prices on energy investments. We consider permits that are allocated and auctioned inside the EU (EUA) and secondary Certified Emission Reductions permits (sCER), which are resold primary CER from the CDM. One price taking firm subject to emission regulation has the choice to invest in a wind power plant, a gas power plant or can choose do to nothing. We find that allowing the usage of offset permits in the present policy framework leads to a lower probability of an investment into wind power taking place.

Opportunistic Behavior in Government Energy Concessions
Carlos Bastian-Pinto (UnigranRio, Brazil)
Luiz Eduardo Brandão (PUC Rio IAG Business School, Brazil)
Leonardo Lima Gomes (PUC Rio IAG Business School, Brazil)
Marta Dalbem (UnigraRio, Brazil)
Rafael Igrejas (PUC Rio IAG Business School, Brazil)
 We model the strategy of an investor who perceives an opportunistic flexibility in a contract for future energy generation under the Real Option approach and investigate whether the perception of uncertainty over capital investments costs and the flexibility of deferring project start or to eventually abandon the project altogether creates an incentive to adopt this opportunistic behavior. We developed a Real Options model that incorporates the value derived from the flexible exercise of investment decisions in the reserve energy auction in Brazil.

Modeling Electricity Prices: Application in a Biomass Power Plant in Brazil
Carlos Frederico Fontoura (Pontifícia Universidade Católica do Rio de Janeiro, Brazil)
Luiz Brandão (Pontifícia Universidade Católica do Rio de Janeiro, Brazil)
Leonardo Gomes (Pontifícia Universidade Católica do Rio de Janeiro, Brazil)
Carlos Bastian-Pinto (Universidade do Grande Rio - Unigranrio, Brazil)
  Brazil’s dependence on hydropower causes the price of short-term energy to behave differently from other markets. In this paper we propose a mean-reverting model with jumps adapted to the Brazilian market and apply it to an elephant grass power plant in two scenarios: a base case with no price uncertainty or operational flexibility and a case with the option to sell part of its energy in the short-term electricity market or switch outputs and sell energy briquettes. The use of the proposed pricing model and insertion of the switch option increased the value of the project by 27.91%.

2:15 - 3:30 Real Estate: Empirical Evidence

Valuing U.S. REITs M&As under Stochastic Volatility
Gianluca Marcato (Henley Business School, University of Reading, United Kingdom)
Tumellano Sebehela (Henley Business School, University of Reading, United Kingdom)
    Real estate investment trusts (REITs) represent a unique laboratory for their institutional settings which lead to industry homogeneity and information availability. Between 1994 and 2009 the US market recorded a wave of mergers and acquisitions (M&A) due to a change in legislation. To illustrate and price exchange options, we extend the Margrabe (1978) model by looking at the impact of internal and external funding and the effect of stochastic volatilities and jumps in M&A pricing. Finally, we find option pricing models to represent actual values better than other valuation methods such as dividend discount models.

Land Conversion Pace under Uncertainty
Luca Di Corato (Dept of Economics, SLU, Sweden)
Michele Moretto (Dept of Economics, University of Padova, Italy)
Sergio Vergalli (Dept of Economics, University of Brescia, Italy)
   In this paper stochastic dynamic programming is used to investigate land conversion decisions taken by a multitude of landholders under uncertainty about the value of environmental services and irreversible development. We study land conversion under competition on the market for agricultural products when voluntary and mandatory measures are combined by the Government to induce adequate participation in a conservation plan. We study the impact of uncertainty on the optimal conversion policy and discuss conversion dynamics under different policy scenarios on the basis of the relative long-run expected rate of deforestation.

Real Options, Financial Frictions and Collateralized Debt: Evidence from Real Estate Firms
Jianfu Shen (The University of Hong Kong, Hong Kong)
Frederik Pretorius (The University of Hong Kong, Hong Kong)
    This paper introduces financial frictions and the collateralized debt capacity of a company within an option framework. The financial constraints and frictions affect option value by forced suboptimal exercise or imposed finance cost. Yet the hard asset in the firm can be used as collateral to ease financial constraint and reduce finance costs. This financial flexibility, modelled as real option interacts with real flexibility. The firm with more assets in place to collateralize may imply larger financial flexibility due to the presence of available collateral. This financial flexibility functions to reduce the distortion of option exercise and increase corporate investment.

4:00 - 4:40 Keynote Address
Avinash Dixit (Princeton University)
A Real Options Perspective on the Future of the Euro

4:45 - 5:45 Panel Discussion
Energy & Real Estate Investing vs. Innovation/Technology and Strategy: Commonalities and Different Perspectives

Moderator: John Kensinger (University of North Texas, USA)

Panelists Include:
Luiz Brandao (PUC Rio, Brazil)
Nuno Gill (U. Manchester, UK)
Anne MacDonnell (Empire Company Ltd, Canada)
Gordon Sick (U. Calgary, Canada)
Babak Jafarizadeh (Statoil, Norway)

5:45 - 7:00 Networking Reception
Sponsored by ROG and Longon Business School


Friday June 29, 2012

9:00 - 10:15 Track I. R&D and Technology Investment

Valuing Managerial Flexibility in Technology R&D
Afzal Siddiqui (University College London, United Kingdom)
     Developing better technologies to adapt to a changing world is crucial for the growth of a knowledge-based economy. Indeed, new products in the areas of energy, pharmaceuticals, and telecommunications generate significant economic benefits. However, in order to maximise those benefits, firms need to devise R&D strategies that are responsive to market conditions. We use real options to provide insights about the value of flexibility in managing technology R&D programmes from the perspective of a knowledge-based firm. Specifically, we account for managerial discretion over the pace of R&D effort and timing of new launches by solving the firm's optimal stopping problem.

Evaluating Real Sequential R&D Investment Opportunities
Roger Adkins (University of Bradford School of Management, United Kingdom)
Dean Paxson (MBS, United Kingdom)
    We provide an analytical solution for American perpetual compound options, that do not rely on a bivariate or multivariate distribution function. This model is especially applicable for a real sequential R&D investment opportunity, such as a series of drug development, tests and clinical trials, where the project can be cancelled at any time, and where the probability of failure declines over stages of completion. Sensitivity analysis indicates significant roles for both variance and covariance.

Technology Adoption With Double Exponential Jump Diffusion
Besma Teffahi (University of Manouba, Tunisia)
     In this paper we develop a model where the technological advancement evolves according to a mixed process. These processes are a combination between the geometrical Brownian motion and the double exponential jump process. The combination of the arrival rate and the size of new technology (NT) confirm the idea that companies wait and adopt the NT when they are sufficiently advanced. We also incorporate absorptive capacity, so the difference between the tow optimum adoption levels of current and future technology becomes lower when the absorptive capacity (AC) of the firm increases.

9:00 - 10:15 Track II. Natural Resources Management & Computation Methods

Real Option Management of Commodity Storage
Selvaprabu Nadarajah (Tepper School of Business, Carnegie Mellon University, United States)
Francois Margot (Tepper School of Business, Carnegie Mellon University, United States)
Nicola Secomandi (Tepper School of Business, Carnegie Mellon University, United States)
   The real option management of commodity conversion assets based on high dimensional forward curve evolution models commonly used in practice gives rise to intractable Markov decision processes. Focusing on commodity storage, we derive approximate dynamic programs from relaxations of approximate linear programs formulated using low dimensional value function approximations. We evaluate the performance of our approximate dynamic programs on natural gas and oil instances.

Power Distribution Investment under Distribution Service Price Uncertainty
Julia Cristina Caminha-Noronha (Federal University of Itajuba - UNIFEI, Brazil)
Jose Wanderley Marangon-Lima (Federal University of Itajuba - UNIFEI, Brazil)
Germano Lambert-Torres (Federal University of Itajuba - UNIFEI, Brazil)
   Power distribution companies face great challenges in balancing profit maximization with the regulatory board requests. Modeling uncertainties has been essential to distribution investment risk assessment. The uncertainties on price the wheeling services add more volatility to the investment return besides the other commonly uncertainties like interest rates and equipment costs. The proposed investment analysis method encompasses the effects of regulation in association with a Real Options framework to valuate investment opportunities under the regulated wheeling charge. Examples coming from a real company are used for illustrating the concepts introduced in this paper.

Valuing Multiple Mining Investment Options
Juan Pablo Garrido (École des Mines de Paris, France)
Stephen Zhang (Pontificia Universidad Católica de Chile, Chile)
    This paper studies two sets of exercising rules in valuing multiple real options, which are common in mining projects. The first set of rules compares and chooses the largest NPV for each path of uncertainty simulated, and the second set uses a polynomial regression based method. The two sets of exercising rules are applied to a promising copper mine with an option to expand and an option to abandon. The value of real options is larger (57%) with the first exercising rule than with the second one (8%). Also we found real options are more important in less promising projects.

10:45 - 12:00 Track I. Human Capital and Entrepreneurship

A Real Options Theory of Strategic Human Resource Management
Lenos Trigeorgis (University of Cyprus, Cyprus)
Francesco Baldi (LUISS - Guido Carli University, Italy)
    Traditional HR architecture, which views different employee groups as a portfolio based on specificity and value, is static and insufficient under uncertainty. We develop an alternative real options portfolio framework based on human capital flexibility or adaptive capability to respond to future contingent landscapes. In dynamic environments there is strategic flexibility value in maintaining active presence in various employment modes (base and flexible). Flexible modes act as a buffer, contracting or expanding in response to unexpected environmental shocks with less cost and time delays. This explains the recent rise in flexible workforce and delays in permanent hiring following down markets.

What is the (Real Option) Value of a College Degree?
Jeffrey Stokes (University of Northern Iowa, United States)
     The value of a college degree is often quantified as the difference in earnings between those with and without a degree. The research presented here operationalizes this idea through a contingent claims model that is sensitive to the valuation of the option to obtain an advanced degree. In this framework, the value of a high school diploma is shown to be the sum of capitalized earnings, the option to obtain an undergraduate degree, and the compound option to obtain an advanced degree. One important finding is that by ignoring these options, the value of a college degree is likely understated.

How and When Entrepreneurs Seek Venture Capital Financing?
Miguel Tavares (University of Porto, Portugal)
Paulo Pereira (University of Porto, Portugal)
Elísio Brandão (University of Porto, Portugal)
   Building on Dixit & Pindyck (1994) model for determining investment timing, this paper develops a real options framework to understand how and when Entrepeneurs seek for Venture Capital financing. The setting comprises an established start-up firm which is deciding between a small or a large expansion project. The Entrepeneur will be seeking Venture Capital financing to carry a larger expansion whether this outprofits the smaller expansion, even at the expense of a lower equity stake. An extension has been designed assuming that the expansion expenditures are divisible and that post-expansion profit is a function of the overall capital expenditure.

10:45 - 12:00 Track II. Optimal Resource Management

Alternative Repeated Investments: Species Choice and Harvest Age in Forestry
Skander Ben Abdallah (University of Quebec at Montreal, Canada)
Lasserre Pierre (University of Quebec at Montreal, Canada)
    We consider the tree planting and cutting decision when two tree species are available with deterministic growth functions and stochastic timber prices. We show that the optimal cutting age depends on the relative timber price and increases when the relative price approaches a threshold value signalling the necessity to switch to the alternative species. The stand value is similar to the value of an American option with a free boundary and an expiry date equals to infinity but with endogenous payoff. The numerical resolution and identification of the continuation region under uncertainty are based on the Penalty Method.

Impact of Multiple Volatilities in Bioenergy Investments
Lioudmila Moeller (Leibniz Institute of Agricultural Development in Central and Eastern Europe (IAMO), Germany)
Alfons Balmann (Leibniz Institute of Agricultural Development in Central and Eastern Europe (IAMO), Germany)
Karin Kataria (Leibniz Institute of Agricultural Development in Central and Eastern Europe (IAMO), Germany)
   The paper investigates the effect of the output and input market volatilities on irreversible bioenergy investments. This effect is studied in a partial equilibrium model which represents the interplay of the global energy market and the local bioenergy and food markets. Volatilities are assumed to stem from normally distributed stochastic shocks to the global energy price and the local food demand. The equilibrium investment trigger of the aggregated bioenergy producer is derived in repeated stochastic simulations. The results demonstrate that the positive correlation between the volatility and investment trigger does not necessarily hold for irreversible investments.

Generation Capacity Expansion in Uncertain Electricity Markets under Rivalry
Bunn Derek (London Business School, United Kingdom)
Michail Chronopoulos (London Business School, United Kingdom)
Bert De Reyck (University College London, United Kingdom)
Afzal Siddiqui (University College London, United Kingdom)
  Due to exposure to uncertainty created by the deregulation of electricity industries, the challenges facing power companies have increased. We propose to extend the traditional real options approach to electricity capacity expansion by investigating game-theoretic issues emerging from the competition between agents, each with a portfolio of electricity production technologies. Such a framework will take into account not only the feedback effect of capacity expansion on the price of electricity and the dependence of the value of a generation unit on the presence of others but also the strategic aspects of capacity expansion in a quasi-analytical framework.

2:00 - 3:15 Track I. Competition & Preemption Games

Cumulative Leadership and New Market Dynamics
Bruno Versaevel (EM LYON Business School & GATE (CNRS), France)
     In a continuous-time model two firms non-cooperatively choose when to invest before competing in quantities. The combined impact on equilibrium outcomes of a persistent first-mover advantage (FMA) and of firms’ ability to detect the new demand, or “alertness” (Kirzner (1973)), is investigated. With limited alertness, simultaneous entry can occur with nonzero probability. A firm maximizes value by entering immediately before its rival, though later than with perfect alertness. A trigger constraint can always be so weak as to be slack in the benchmark scenario (perfect alertness and no FMA), and still result in more equilibrium value to the leader.

Equilibria in Continuous Time Preemption Games
Jacco Thijssen (University of York, United Kingdom)
     This paper studies timing games in continuous time where payoffs are stochastic, strongly Markovian, and spectrally negative. The main interest is in characterizing equilibria where players preempt each other along almost every sample path as opposed to equilibria where one of the players acts as if she were the (exogenously determined) leader in a Stackelberg game. It is found that the existence of such preemptive and Stackelberg equilibria depends crucially on whether there is a coordination mechanism that allows for rent equalization or not. Such a coordination mechanism is introduced and embedded in the timing game.

Rivalry with Market and Technical Uncertainty in the Adoption of New Technologies
Alcino Azevedo (University of Hull, United Kingdom)
Dean Paxson (University of Manchester, United Kingdom)
    Firms often optimize investment decisions on new technologies in contexts where market and technical uncertainty hold. We derive a multi-factor pre-emption real options game model for a duopoly market, and get analytical or quasi-analytical solutions for the firms’ value functions and investment thresholds. We show that technical uncertainty has an asymmetric effect on the firms’ investment behaviour, delaying significantly the investment of the follower and only slightly the investment of the leader and that the size of the leader’s “first-mover market share advantage”, speeds up slightly the investment of the leader and delays significantly the investment of the follower.

2:00 - 3:15 Track II. Sequential & Infrastructure Investment

Valuation and Capital Cost of Flexibility in Sequential Investment
Steinar Ekern (NHH, Norway)
Mark Shackleton (LUMS, United Kingdom)
Sigbjorn Sodal (UiA, Norway)
   For time homogeneous problems, in this paper we separate the diffusion choices from the flexibility sequencing. This is done by placing the investment structure within a mathematical graph that captures the flexibility sequence. In order to value the optionality, discount functions standardized for the diffusion choice are placed within a matrix representing the project's investment sequence. Under a range of diffusion choices, for perpetual, cyclical and non-cyclical investment sequences this allows investment cost and project values to be determined explicitly as a function of trigger levels. Thus insights are offered concerning valuation and capital costs of flexibility.

Optimal Investment in Modular Nuclear Reactors
Shashi Jain (TU Delft, Netherlands)
Ferry Roelofs (Nuclear Research Group, Netherlands)
Cornelis Oosterlee (CWI, Netherlands)
   Small and medium sized reactors, SMRs, are considered as an attractive option for investment in nuclear power plants. SMRs may benefit from flexibility of investment, reduced upfront expenditure, enhanced safety, and easy integration with small sized grids. Large reactors on the other hand have been an attractive option due to the economy of scale. In this paper using real option analysis we help a utility determine the value of sequential modular SMRs. Numerical results under different considerations, like possibility of rare events, learning, uncertain lifetimes are reported for a single large unit and for modular SMRs.

Real Options Portfolios and Capacity Expansion in Transmission Network Expansion
Manuel Loureiro (Inesc Tec / Universidade do Porto, Portugal)
Paulo J. Pereira (Universidade do Porto, Portugal)
João Claro (Inesc Tec / Universidade do Porto, Portugal)
   In network investments, much of the real options value may reside "in" identifying the proper configuration to develop, in terms of the timing and sizing of its deployment. A longer-term perspective, with a treatment of uncertainty that moves beyond simply increasing deterministic specifications, has the potential to improve the design of networked infrastructures. In this paper we present a new model for Transmission Network Expansion Planning, with uncertainty in demand, which considers investments in transmission lines as a portfolio of real options, and we study the impact of uncertainty and demand correlation in basic network building blocks.

3:45 - 5:00 Track I. Differentiation, Dynamic Pricing & Competition

Product Differentiation and Option Games
Carlos Deck (Universidad de los Andes/Pontificia Universidad Católica de Chile, Chile)
Jaime Casassus (Pontificia Universidad Católica de Chile, Chile)
   Up to now, the Option Games literature has studied oligopolistic markets where firms compete à la Cournot, leaving aside markets with other strategic variables, such as prices. To address this issue, a model is built where Hotelling’s linear city model is adapted, to include the tradeoff between preempting competitors under uncertainty or waiting to know where the city’s customers are. Solving this model shows that multiple symmetrical entry patterns are possible, depending on the coordination of both firms. These results are then used to give plausible explanations to markets ranging from smartphones to political elections.

Dynamic Pricing Strategies with Baysian Learning
Paul Johnson (University of Manchester, United Kingdom)
Andreas Papayiannis (University of Manchester, United Kingdom)
Kevin Poquet (ENSTA ParisTech, France) 
  In this paper we investigate the problem of the seller who has fixed time in which to sell stock but is uncertain about the model governing price and demand. We assume there exists a finite set of possible models from which the true one is randomly chosen and remains fixed through time. The seller has different optimal strategies for each model, so we develop a new algorithm that chooses between strategies taking into account model misspecification. We test using simulations and the results show that by using Bayesian learning we can see an increase of up to 10% in revenues.

Cooperative and Competitive Gas Processing
Yuanshun Li (Ryerson University, Canada)
Gordon Sick (University of Calgary, Canada)
    Natural gas producers drill their own wells, but need gas plants to process gas for shipping to market. These facilities are built by a first-mover, which can lease its facility to adjacent producers to enable production of their gas. The first-mover advantages are that the plant can be customized to the builder’s needs and economic rents can be earned on leases. If gas prices are high or field reserves are large, a second mover can (and often does) build its own plant. This paper extends the earlier models of Li and Sick [2007, 2010, 2011] with more empirical evidence.

3:45 - 5:00 Track II. Environmental Management & Policy

Sequential Investment in Pollution Control Equipment
Motoh Tsujimura (Doshisha University, Japan)
     We assume that a firm's output generates a pollution by-product and the pollution reduces the productivity of capital. Then, the firm has to invest in pollution control equipment in order to reduce the pollutant and it incurs equipment cost. In this paper, we assume that the firm can invest it as needed. Then, the firm's problem is to choose the investment timing under uncertainty and is formulated a singular stochastic control problem. We solve the firm's problem by using variational inequalities and obtain the optimal investment strategy which is described by the threshold to invest in the pollution control equipment.

Time is Running Out: The 2°C Target and Optimal Policies
Yu-Fu Chen (University of Dundee, United Kingdom)
Michael Funke (Hamburg University, Germany)
Nicole Glanemann (Hamburg University, Germany)
   The quintessence of recent natural science studies is that the 2°C target can only be achieved with massive emission reductions in the next few years. The central twist of this paper is the addition of this limited time to act into a non-perpetual real options framework analysing optimal climate policy under uncertainty. The window-of-opportunity modelling setup shows that the limited time to act may spark a trend reversal in the direction of low-carbon alternatives. However, the implementation of a climate policy is evaded by high uncertainty about possible climate pathways.

Dark Clouds or Silver Linings? Knightian Uncertainty and Climate Change
Yu-Fu Chen (University of Dundee, United Kingdom)
Michael Funke (Hamburg University, Germany)
Nicole Glanemann (Hamburg University, Germany)
   This paper examines the impact of Knightian uncertainty upon optimal climate policy through the prism of a continuous-time real option modelling framework. We analytically determine optimal intertemporal climate policies under ambiguous assessments of climate damages. Additionally, numerical simulations are provided to illustrate the properties of the model. The results indicate that increasing Knightian uncertainty accelerates climate policy, i.e. an ambiguity-averse policy maker become more reluctant to postpone the timing of climate policies into the future. However, we find that the size of this effect is rather small, which indicates that Knightian uncertainty is no "carte blanche" for extreme policy activism.

Saturday June 30, 2012

9:00 - 10:15 Track I. Leverage, Taxes & Agency Issues

Taxes, Leverage and Stimuli of Investment under Uncertainty
Kit Pong Wong (University of Hong Kong, Hong Kong)
     This paper examines the effect of leverage on the effectiveness of a tax-subsidy program offered by a government in stimulating a firm's investment. We show that the firm has an incentive to hasten its investment due to agency conflicts. We further show that there is a countervailing incentive to defer investment due to bankruptcy costs. We provide sufficient conditions under which the former incentive is dominated by the latter incentive. The tax-subsidy program thus induces the levered firm to defer, not hasten, its investment. Finally, we show that the levered firm is made worse off with than without the program.

Efficiency, Leverage and Exit: The Role of Information Asymmetry in Concentrated Industries
Baran Siyahhan (Aarhus University, Denmark)
     This paper develops a real options model of imperfect competition with asymmetric information that analyzes firms’ exit decisions. Optimal exit decision is linked to firm characteristics such as financial leverage and efficiency. The model shows that informational asymmetries between product market rivals can lead more efficient and less leveraged firms to leave the product market prematurely. Moreover, the firm’s debt capacity is bounded by the rival firms’ leverage.

Duopolistic Investment with Agency Risk and Contract Design
David Cardoso (School of Economics - University of Porto, Portugal)
Pereira Paulo (School of Economics - University of Porto, Portugal)
    Real options theory frequently assumes that investment decisions are directly taken by the owners or, if there is a manager, he is fully aligned with them. However, empirical literature demonstrates that managers may reveal misaligned interests, which may affect value maximizing decisions. This paper provides a contribute to the existing real options by dropping this assumption in the non-exclusive option case, specifically providing a duopolistic leader-follower framework where an agency problem between the owners of the option and their respective managers, is embodied and solved by an optimal labor contract scheme that aims to eliminate inadequate actions from the managers.

9:00 - 10:15 Track II. Theoretical Models & Issues

Managerial Risk Aversion in Real Option Valuation of Early Stage Investments
Sebastian Jaimungal (Univeristy of Toronto, Canada)
Yuri Lawryshyn (Univeristy of Toronto, Canada)
    In this work, we build on a previous real options approach that utilizes managerial cash-flow estimates to value early stage project investments, but accounting for managerial risk aversion. We introduce a market sector indicator, which is assumed to be correlated to a tradeable market index, which, through a mapping function, drives and replicates the cash-flow estimates. The mapping allows us to link the cash-flow estimates to many theoretical real options frameworks which currently can not be applied in practice. Through indifference pricing we are able to model the effect of managerial risk aversion for any given set of cash-flow estimates.

A Binomial Lattice Approach for Generic One Factor Markov Processes
Carlos Bastian-Pinto (UnigraRio, Brazil)
Luiz Eduardo Brandão (PUC Rio IAG Business School, Brazil)
Luiz Ozorio (Ibmec Business School, Brazil)
   In this paper we propose a Symmetrical Binomial Lattice Approach that is equivalent to the well-known and widely utilized Lattice of Cox, Ross & Rubinstein (1979) when modeling Geometric Brownian Motion type of processes, but can be utilized for a wide variety of other Markov style stochastic processes. This is due to the highly intuitive construction in which first the expected value expression of the process is directly used and the variance is modeled in a symmetrical lattice, which is added to the first. We then demonstrate its applicability with several Real Options examples, comparing to the Cox model.

Capital Budgeting in Competitive Markets using Options and Games: The Case of Telecom
Marco Araujo (University of Porto – School of Economics, Portugal)
     This paper presents a novel method to evaluate the economic feasibility of Fiber-to-the-Home networks resorting to state-of-the-art techniques. The method presented in this paper is a powerful combination of game theory, advanced capital budgeting algorithms with real options and Monte Carlo simulations with complex statistical distributions to evaluate project risk

10:45 - 12:00 Track I. Information, Uncertainty & Asset Pricing

Income Smoothing When Insiders Know More Than Outsiders
Viral Achary (New York University, United States)
Bart Lambrecht (University of Lancaster, United Kingdom)
    We consider a setting in which insiders have information about income that outside shareholders do not, but property rights ensure that outside shareholders can enforce a fair payout. To avoid intervention, insiders report income consistent with outsiders' expectations based on publicly available information rather than true income, resulting in an observed income and payout process that adjust partially over time towards a target. Insiders under-invest in production and effort so as not to unduly raise outsiders' expectations about future income, a problem that is more severe the smaller is the inside ownership and results in an ``outside equity Laffer curve".

Explaining Bubbles in Open Economies
Kirill Zavodov (University of Cambridge, United Kingdom)
Henri Buchsteiner (University of Cambridge, United Kingdom)
    Common precursors of financial crises are credit expansion and rising leverage. These fuel bubbles that result in a severe economic downturn when they burst. However, existing literature on bubbles under rationality lacks explanatory power, and this paper argues that this may be partly due to an implicit focus on closed economies. We study risk-shifting bubbles in symmetric open economies with three different investor types: conventional, speculative and value investors. In open economies, credit bubbles tend to be `displaced' abroad, have higher incidence, are larger, and last longer relative to the closed economy setting.

Irreversible Commitment and Price Negotiation under Knightian Uncertainty
YL Gao (Business School, Central University of Finance and Economics, China)
Tarik Driouchi (Department of Management, King's College, United Kingdom)
    This paper tackles the problem of irreversible investment and price negotiation under Knightian uncertainty. We present a multiple-priors based formulation of utility that distinguishes between risk and uncertainty in decision-making to study the impact of vagueness/ambiguity on bilateral price negotiation. Specifically, we examine negotiation dynamics between a buyer and a seller to derive thresholds for optimal commitment, identify conditions under which mutual agreement is warranted, and estimate likelihood of agreement under deep economic uncertainty. Besides generalizing risk uncertainty results found in prior research, our findings provide insights into the formulation of robust optimal (buying/selling) strategies for negotiation under ambiguity.

10:45 - 12:00 Track II. Investment under Complex Structures & Regime Switching

Innovation Investments with Weighted Average Polynomial Option Pricing
Elena Rogova (National Research University Higher School of Economics, Russia)
Andrey Yarygin (National Research University Higher School of Economics, Russia)
    This paper contains the analysis of pitfalls connected with innovation-based investments valuation. Being long-term projects with high uncertainty, innovation-based investments suffer from different types of mistakes if traditional discounted cash flow methodology is used for their valuation. The real options approach is being used for a long time, but this paper proposes an original approach based upon the consideration of the wide variety of project implementation scenarios. The weighted average polynomial option pricing model presented here may help investors to increase the quality of decisions about their participation in innovation-based opportunities.

Irreversible Investment with Regime Switching
Keiichi Tanaka (Tokyo Metropolitan University, Japan)
    We consider irrevesible investment problems with regime switching feature under a monopoly setting. Several parameters describing the economic environment varies according to a regime switching with general number of states. We present the derivation of the value function via solving a system of simultaneous ordinary differential equations with knowledge of linear algebra. It is found that the functional form of the value function depends on the decomposition of a coefficient matrix. It enables us to investigate a comparative analysis of the investment problem.

Irreversible Investments under Competition with Markov Switching Regime
Makoto Goto (Hokkaido University, Japan)
Katsumasa Nishide (Yokohama National University, Japan)
Ryuta Takashima (Chiba Institute of Technology, Japan)
   In this paper, we study an investment problem in which multiple firms face an investment competition and the regime characterizing economic conditions follows Markov switching. We derive the value functions and investment thresholds of the leader and followers. We will find with numerical examples that in contrast to the case of no regime switching, even if the current market size is small, both advantaged and disadvantaged firms have an incentive to become a leader in some parameter settings.

12:00 – 1:00 Panel Discussion: Current State, Challenges and Future Prospects

Moderator: Gordon Sick (U. Calgary)
Panelists Include:
Luiz Brandão (PUC-Rio, Brazil)
Jaime Casassus (PUC-Chile, Chile)
John Kensinger (U. North Texas, USA)
Bart Lambrecht (U. Lancaster, UK)
Pierre Lasserre (U. Quebec, Canada)
Dean Paxson (U. Manchester, UK)
Sigbjorn Sodal (Agder U., Norway)
Jacco Thijssen (U. York, UK)

1:00 Closing Remarks
Conference Concludes

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