Day 0 – Wednesday, June 15 (See Managerial Conference Program)
6:00-8:00 pm Holmenkollen Ski Museum and Reception
Day 1 – Thursday, June 16 (Oslo)
8:15-8:45 Registration & Coffee
8:45-8:55 President's Welcome
9:00-10:15 Track I
Energy & Resource Applications
Chairperson: Diderik Lund (U. of Oslo, Norway)
Chiara D'Alpaos, Marina Bertolini, Michele Moretto (DSEA - University of Padova, IT)
Discussant: Wen Chen (Commonwealth Scientific & Industrial Research Organisation, AU)
In Italy and in many EU countries, the last decade was characterized by a large development of distributed generation power plants. Their presence determined new critical issues for the design and management of the overall energy system and the electric grid due to the presence of discontinuous production sources. It is commonly agreed that contingent problems that affect local grids (e.g. inefficiency, congestion rents, power outages, etc.) may be solved by the implementation of a “smarter” electric grid. The main feature of smarts grid is the great increase in production and consumption flexibility. Smart grids give producers and consumers, the opportunity to be active in the market and strategically decide their optimal production/consumption scheme. The paper provides a theoretical framework to model the prosumer’s decision to invest in a photovoltaic power plant, assuming it is integrated in a smart grid. To capture the value of managerial flexibility, a real option approach is implemented. We calibrate and test the model by using data from the Italian energy market.
Thermal Power Portfolio Valuation: A Fuzzy Real Options Application in Brazil
Wallace José Damasceno do Nascimento (PUC-Rio, BR), Marco Antonio Dias (Petrobras, BR), Marco Aurélio Pacheco (PUC-Rio, BR)
Discussant: Chiara D'Alpaos (DICEA - University of Padova, IT)
In Brazil, Energy Market players dedicate many efforts in valuation and optimal allocation of capital decision to implement projects, due the large candidate projects number in their investment portfolios. The strategic decisions of those players should choose the projects subset that will be implemented, because usually, they don´t have the financial resources to implement all then. Many are the risks presented, and greater are uncertainties, greater become the difficulties to value these investment decisions optimally. Complex problems and possible changes in economic and business scenarios can make it even harder. Classical investment portfolio valuation and optimization is based on the maximizing returns (NPV, IRR) and minimizing risks (NPV standard deviation, variance) concepts. But often, traditional methods of assessment may not be able to properly handle the projects managerial flexibilities (Real Options) and meet the great need for prediction for the management of risks and uncertainties due to possible intrinsic difficulties solution and mathematical modeling (multi-variable) problems. Thus, there is an ample room to alternative models´ development and implementation models, such as those based on Real Options Theory, including the use of Computational Intelligence methods. In this work is proposed a Fuzzy Real Options valuation to candidate projects, in a Thermal Power Generation market player, considering managerial flexibilities in uncertain environment. To project portfolio selection is provided the application of a Genetic Algorithm Optimization.
Optimal Natural Resource Extraction with Production Target: An Application in Mining
Wen Chen (Commonwealth Scientific & Industrial Research Organisation, AU), Nicolas Langrené, Tanya Tarnopolskaya (Commonwealth Scientific & Industrial Research Organisation, AU)
Discussant: Wallace José Damasceno do Nascimento (PUC-Rio, BR)
We consider the problem faced by mining companies to set their extraction rate over time in order to meet their production targets, from a real option perspective. As part of their strategic planning, mining companies usually set a production target for a given, short-term to medium-term, time horizon. The extraction rate is constrained by this target, but remains flexible around a certain base rate. Because of the uncertainty in commodity prices, this flexibility has a value. Basically, by slowing down production when prices are low and speeding up production when prices are high, the miner can still meet its production target exactly, while at the same time significantly increase the value of the mine. Mathematically, this resource extraction problem can be described as a multi-regime constrained stochastic control problem. The control is the extraction rate, to be set for every time step, and the constraint is the total extraction volume over the whole time period. We solve this problem numerically using an extension of the simulation-based Least-Squares Monte Carlo algorithm. To deal with the endogenous reserve variable, we use the so-called control randomization technique. The estimated mine value increase would be nothing without the roadmap to achieve this improvement in practice. Fortunately, our numerical solution provides the optimal extraction regime to apply over time, for any commodity price level and any reserve level. We summarize the information about the optimal regime switching surfaces into intuitive graphics that can assist industry for their sequential production decisions under uncertainty in practice.
9:00-10:15 Track II
Energy Policy & Subsidies
Chairperson: Kristin Linnerud (CICERO, Norway)
Investment Criteria for Subsidized Energy Facilities
Dean Paxson (Manchester Business School, GB), Roger Adkins (Bradford University, GB)
Discussant: Verena Hagspiel (Norwegian University of Science and Technology, NO)
We derive the optimal investment timing and real option value for an investment opportunity in a subsidized energy facility with possible price, quantity and subsidy uncertainty. Notable findings are that the initial subsidies justifying immediate investment are lowered by subsidies unlikely to be withdrawn, but decreasing over time, and by reducing the output price volatility and interest rates.
Renewable Energy Investment Policy with Support Schemes Uncertainty
Trine Boomsma (University of Copenhagen, DK), Kristin Linnerud (CICERO Center for International Climate and Environmental Research, NO)
Discussant: Dean Paxson (Manchester Business School, GB)
We consider the impact of a change in policy on investment in renewable energy. Our focus is how investment rates are affected by the probability of a revision of the current support scheme for renewable energy, aimed at incentivising producers to respond to market developments. For analysis, we use a real options model for investment timing under both market and policy uncertainty. We show that with the probability of a change from a feed-in tariff to a price premium, exposure to market risk increases. Assuming a change in risk exposure only, the expected value of an operating project remains unaffected by the prospects of revision. However, the potential increase in volatility of future revenues creates a value of waiting and thereby an incentive to postpone investment.
Subsidised Capacity Investment under Uncertainty
Verena Hagspiel (Norwegian University of Science and Technology, NO), Xingang Wen (Tilburg University, NL), , Peter Kort (Tilburg University, NL)
Discussant: Trine Boomsma (University of Copenhagen, DK)
This research work studies how the subsidy support, e.g. price support and reimbursed investment cost support, affects the investment decisions for the monopoly firm and the social welfare under uncertainty. It is shown that subsidy encourages earlier investment at the cost of investing less. There exists optimal subsidy rates to align the firm's investment decisions to decisions that maximise social welfare. Costs of subsidy are also analysed. Comparison is made among different subsidy measures.
10:15-10:45 Morning Coffee Break
10:45-12:00 Track I
Energy Infrastructure Investment
Chairperson: Kjell Arne Brekke (U. of Oslo, Norway)
Optimal Energy Transmission Infrastructure Investment Between Regions
Kjell Arne Brekke (U. of Oslo, NO)
Discussant: Afzal Siddiqui (University College London, GB)
We consider investment in energy transmission capacity between two region with uncertain demand in both regions. We show that even though an investor may learn about future price differences by waiting to invest, increased uncertainty also increases the value of the investment, and dominates the learning effect. As a consequence it is optimal to invest earlier the higher the uncertainty.
Valuing Natural Gas Pipeline Expansion: An Application in Mexico
Ricardo Massa (EGADE Business School, Tecnologico de Monterrey, MX), Montserrat Reyna (EGADE Business School, Tecnologico de Monterrey, MX)
Discussant: Kjell Arne Brekke (U. of Oslo, NO)
One of the main methodological challenges of the real option valuation is to recognize and account for multiple underlying assets and their impact on the volatility of the project. Even though, notable contributions are found in order to develop a “rainbow real option” approach, its use is somewhat limited. This work proposes a Copula-GARCH methodology to be used within the real option valuation. The main objective is to exploit the advantages of the volatility treatment, through GARCH models, and the dependence structure determination, through copula modeling, and apply them in the real option valuation. The methodology is applied to the valuation of the Mexican natural gas pipeline expansion project “Los Ramones”, with the USD-MXN exchange rate and the natural gas price as underlying assets. We use individual TGARCH models to estimate the volatility and terminal value of two assets, then use copula modeling to determine a measure of association between them in order to define their joint volatility, here six copulas are proposed the Normal, Student’s t, Clayton, Gumbel, Frank and Tawn and their pertinence is discussed. Finally, the information obtained in the previous steps is used as input in the real option context for the valuation of the project. Our findings suggest the project should be taken, as with four of the copulas (Normal, Student’s t, Clayton and Frank) the value for the real option is positive.
The Impact of Uncertain Revenues and Costs on Time-to-Build in Energy Infrastructure Investment
Afzal Siddiqui (University College London, GB), Lauri Kauppinen, Ahti Salo (Aalto University, FI)
Discussant: Ricardo Massa (EGADE Business School, Tecnologico de Monterrey, MX)
Lagging public-sector investment in infrastructure and the deregulation of most industries mean that decisions will have to be made increasingly by the private sector under multiple sources of uncertainty. We enhance the traditional real options approach to analysing investment under uncertainty by accounting for both multiple sources of uncertainty and the time-to-build aspect. The latter feature arises in the energy and transportation sectors because investors can decide the rate at which the project is completed. Furthermore, two explicit sources of uncertainty represent the discounted cash inflows and outflows of the completed project. We use a finite-difference scheme to solve numerically for both the option value and the free boundary that characterises the optimal investment strategy. Somewhat counterintuitively, we find that with a relatively long time to build, a reduction in the growth rate of the operating cost may actually lower the investment threshold. This is contrary to the outcome when the time-to-build aspect is ignored in a model with uncertain price and cost. Hence, research and development efforts to enhance emerging technologies may be more relevant in infrastructure projects with long lead times.
10:45-12:00 Track II
Resource and Environmental Policy
Chairperson: Motoh Tsujimura (Doshisha U., Japan)
Environmental Regulation and Entry-Exit Decisions
Motoh Tsujimura (Doshisha University, JP), Makoto Goto (Hokkaido University, JP), Ryuta Takashima (Tokyo University of Science, JP)
Discussant: Tine Compernolle (Hasselt University, BE)
In this paper, we study environmental regulation and market equilibrium. Existing literature consider pollution taxes, tradable emission permits and imperfect competition, however, they do not consider any uncertainty. We consider demand uncertainty and investigate dynamics of emission amount and equilibrium market supply under the environmental regulation.
Optimal Resource Rent Taxation Policy under Credit Constraints
Diderik Lund (University of Oslo, NO)
Discussant: Motoh Tsujimura (Doshisha University, JP)
The Resource Rent Tax suggested by Garnaut and Clunies Ross (1975) has been influential in resource rich countries and in academic literature. Several authors show that it distorts investments through asymmetric treatment of profits and losses. Neutrality can only be achieved if authorities commit to treating these symmetrically, guaranteeing loss offset through payouts if necessary. Risks are substantial, both in output (technology, geology) and (output and factor) prices. Many nations will be unable or unwilling to take risks involved in such guarantees. We analyze optimal rent taxation in this situation, maximizing tax revenue subject to a constraint of no loss offset.
Can Complementary Investments Reduce the Impact of Uncertainty? CO2 Enhanced Oil Recovery
Tine Compernolle (Hasselt University, BE), Kuno Huisman (Tilburg University, NL), Kris Welkenhuysen, Kris Piessens (Royal Belgian Institute of Natural Sciences, BE), Peter Kort (Tilburg University, NL)
Discussant: Diderik Lund (University of Oslo, NO)
To reach the transition towards resource efficient, low carbon economies the involvement of all economic actors is required. Focus of this paper is on combined investment decisions that result in multiple uncertain revenue streams. The developed model is based on the theoretical framework provided by Adkins and Paxson (2011) and is applied for a case study on CO2 enhanced oil recovery. In contrast to standard real options theory, We show that when complementary activities that require separate investments can be fully integrated, the revenue streams resulting from the different underlying assets are mutually reinforcing. If the revenues from these investments are not highly correlated, and if the revenue stream of one underlying asset is relatively high, uncertainty in the revenue resulting from the other underlying asset stimulates total investment. This result suggests that the firm is not only protected from a downside risk by having the option to invest. Also the higher revenues of the other asset protect the firm from this risk, even though there is uncertainty in these revenues as well.
12:00-12:40 Managerial Keynote Address
Twenty Years of Real Options: From Theory to Practice and Back
Kuno Huisman (Tilburg U., NL)
12:45 Closing Remarks
2:00-8:45 pm Train to Trondheim (Academic Conference Continues)
Day 2 – Friday, June 17 (Trondheim)
9:00-10:15 Track I
Stochastic Processes & Modeling Approaches
Chairperson: Elizabeth Whalley (U. of Warwick, UK)
Choice of Stochastic Processes for Real Option Valuation Problems
Carlos Bastian-Pinto (Ibmec Business School, BR), Luiz Brandão (PUC-Rio, BR), Luiz Ozorio (IBMEC Business School, BR)
Discussant: Kimiya Oshikoji (Norwegian School of Economics, NO)
A main issue in financial derivatives and real options valuation is the choice of an adequate stochastic model to describe the price dynamics of the underlying asset. Particularly, in investment projects where there is significant managerial flexibility, the choice of stochastic process can have significant impacts on the project value and, therefore, the investment rule. This paper discusses several criteria for stochastic processes selection between Brownian Motion and Mean Reversion and the related theoretical, as well as practical, issues concerning the application of these to real options valuation. Empirical examples are used to illustrate the methods described along with guidelines for their implementation.
Elizabeth Whalley (University of Warwick, GB), Ciara Dangerfield (University of Cambridge, GB), , Nicholas Hanley (University of St Andrews, GB), Christopher Gilligan (University of Cambridge, GB)
Discussant: Carlos Bastian-Pinto (Ibmec Business School, BR)
The real options approach has been used within environmental economics to investigate the impact of ecological uncertainty on the optimal timing of control measures to minimise the impacts of invasive species and diseases. Previous studies typically model the growth in invaded or infected area using geometric Brownian motion (GBM). The advantage of such an approach is that it is simple and allows for closed form solutions. However, such a process is unbounded and so does not respect the natural upper boundary of the system which is determined by the maximum size of the host species. We show how the natural upper boundary can be incorporated endogenously into the decision problem, through the formulation of the stochastic process that describes growth in infected area. Furthermore, we show that such a process is equivalent to the susceptible-infected (SI) model which is widely used within the epidemiological literature. We find that ignoring the natural upper boundary of the system overestimates the value of the option to control, leading to delayed application of treatment. Indeed, when uncertainty is high or the disease is fast spreading then ignoring the upper boundary can lead to control never being deployed. Thus the results presented here have important implications for the way in which the real options approach is applied to determine optimal timing of disease control given uncertainty in future disease progression.
The Impact of Technological Uncertainty on Project Scale
Kimiya Oshikoji (Norwegian School of Economics, NO)
Discussant: Elizabeth Whalley (University of Warwick, GB)
The interaction between uncertainty and managerial discretion is a crucial relationship in a firm’s investment decision. Particularly, as a disruptive technology can precipitate the failure of a leading firm, a project under technological uncertainty can largely benefits from an investment strategy where the potential effects of a disruptive technology can be weighed in an incumbent technology project’s valuation. Hence, in this thesis, a price-taking firm that has managerial discretion over both investment timing and the size of a project under price and technological uncertainty is considered. By constructing an analytical framework, it is shown that in comparison to solely price uncertainty, a project under low price and technological uncertainty will have both a lower optimal investment threshold and corresponding optimal capacity, whereas, under conditions of high price and technological uncertainty, a project will have a higher optimal investment threshold and corresponding optimal capacity. Additionally, directly revoking standard real options intuition, it is established through numerical results that the firm’s optimal investment policy will be monotonically decreasing as a function of technological uncertainty.
9:00-10:15 Track II
Energy Games Applications
Chairperson: Artur Rodrigues (U. of Minho, Portugal)
Urban Infrastructure Investments: Strategic Interactions in UK District Heating Networks
Sebastian Maier, John Polak (Imperial College London, GB)
Discussant: Luciana Barbosa (MIT Portugal Program and Instituto Superior Técnico, Universidade de Lisboa, PT)
The performance of investments in systemic urban infrastructures such as in energy, transport, water, waste and ICT is frequently affected by enormous uncertainty surrounding intrinsic technical and other risks, exogenous volatility in supply and demand conditions and by the strategic interactions of multiple decision makers with often competing interests. As such, the application of option games, which combine real option analysis to investment under uncertainty and game theory to study decision makers’ competing behaviours, appears to be a promising avenue for the analysis of such complex investment problems. However, existing option game models generally take a corporate perspective, use continuous-time models and aim at the provision of analytical solutions, which makes them both impractical and inadequate. This paper presents a new discrete-time, option games-based appraisal framework for selecting a portfolio of interdependent urban infrastructure investments. Representing the decision makers’ flexibilities through influence diagrams and mathematically modelling their strategic interactions, we have used this framework to formulate a multi-stage stochastic optimisation model that combines Monte Carlo simulation for scenario generation with the approximation of the value functions through simple least-squares. Using the real-case of district heating network investments in London, we investigate the sensitivity of the optimal portfolio value to changes in both decision makers' strategic behaviour and demand and supply patterns. The numerical results demonstrate that our approach has substantial potential to enhance and support long-term, strategic investment decisions, particularly with regard to timing and scale, but also short-term, operational decisions, for example to switch between different modes of operation.
Transmission Planning and Power Generation Investment under Uncertainty
Verena Hagspiel (NTNU, NO), Afzal Siddiqui (UCL, GB), Jannicke Sleten, Nora Midttun (Norwegian University of Science and Technology, NO)
Discussant: Sebastian Maier (Imperial College London, GB)
The challenge of deregulated electricity markets and ambitious renewable energy targets have contributed to an increased need of understanding how market participants will respond to a transmission planner’s investment decision. We study the optimal transmission investment decision of a transmission system operator (TSO) that anticipates a power company’s (PC) potential capacity expansion. The proposed model captures both the investment decisions of a TSO and PC and accounts for the conflicting objectives and game-theoretic interactions of the distinct agents. Taking a real options approach allows to study the effect of uncertainty on the investment decisions and taking into account timing as well as sizing flexibility. We find that disregarding the power company’s optimal investment decision can have a large negative impact on social welfare for a TSO. The corresponding welfare loss increases with uncertainty. The TSO in most cases wants to invest in a higher capacity than is optimal for the power company. The exception is in case the TSO has no timing flexibility and faces a relatively low demand level at investment. This implies that the TSO would overinvest if it would disregard the PC’s optimal capacity decision. On the contrary, we find that if the TSO only considers the power companies sizing flexibility, it risks installing a too small capacity. We furthermore conclude that a linear subsidy in the power company's investment cost could increase its optimal capacity and therewith, could serve as an incentive for power companies to invest in larger capacities.
Renewable Energy Policy: Feed-in Tariffs with Minimum Price Guarantees
Luciana Barbosa (MIT Portugal Program and Instituto Superior Técnico, Universidade de Lisboa, PT), Artur Rodrigues (University of Minho, PT), Alberto Sardinha, Paulo Ferrão (University of Lisbon, PT)
Discussant: Verena Hagspiel (NTNU, NO)
Policy intervention can impact the decision making process of deploying a renewable energy project. The feed-in tariff program is a popular policy for incentivizing new renewable energy projects, because it establishes a long-term contract with renewable energy producers. This paper combines an asymmetric Stackelberg model with a real options valuation model in order to analyze a feed-in tariff with a minimum price guarantee. The model identifies the optimal time to deploy a renewable energy project, and shows how the value and duration of a minimum price guarantee may affect the investment threshold and the value of the project. The results show that perpetual guarantee does not exist and the greater the feed-in tariff value, the sooner the time of investment. In addition, our model provides a powerful tool to analyze investment in renewable energy projects where we take into account managerial flexibilities and feed-in tariff policy within an oligopoly market.
10:45-12:00 Track I
Valuing and Managing Storable Resources
Chairperson: Yuri Lawryshyn (U. of Toronto, Canada)
A Stochastic Supply/Demand Model for Storable Commodity Prices
Yuri Lawryshyn, Ali Bashiri (University of Toronto, CA)
Discussant: Reinhard Madlener (RWTH Aachen University, DE)
We develop a two-factor mean reverting stochastic model for forecasting storable commodity prices and valuing commodity derivatives. We define a variable called “normalized excess demand” based on the observable production rate, consumption rate, and inventory levels of the commodity. Moreover, we formulate and quantify the impact of this factor on the commodity spot and futures prices. We apply this model to crude oil prices from 1995 to 2016 via a Kalman filter. Our analysis indicates a strong correlation between normalized excess demand and crude oil spot and futures prices. We analyze the term structure of futures prices under the calibrated parameters as well as the implications of changes in the underlying factors.
Natural Gas Storage using Mean Reverting Jump Diffusion
Kristian Støre (Nord University, NO), Svetlana Borovkova, Bas Henke (Vrije University Amsterdam, NL)
Discussant: Dean Paxson (Manchester Business School, GB)
We combine the approximation scheme for jump diffusions proposed by Amin (1993) with results from Nelson and Ramaswamy (1990) for how to model mean reversion in a binomial lattice. Pairing these two approaches we propose a discrete time approximation of prices that follow a mean-reverting jump-diffusion (MRJD) process. Commodity prices are often associated with price processes exhibiting these characteristics, e.g. electricity and natural gas prices. We apply the proposed approximation scheme to determine the value and optimal injection/extraction strategy for a gas storage facility, assuming that natural gas prices (Henry Hub) follow a MRJD. Implementation of the model is straightforward and it is flexible for adaptation to the valuation of other real options or derivatives with the same type of underlying price process.
Reinhard Madlener (RWTH Aachen University, DE), Xavier de Graaf (RWTH Aachen University, DE)
Discussant: Kristian Støre (Nord University, NO)
Intermittent electricity production due to increasing shares of renewable energies, carbon cap-ture and storage technologies to retard climate change and the increasing usage of hydrogen for transport applications have one thing in common: They all need long-term large-scale storage facilities. Consequently, a future competition for the most cost-efficient storage sites is likely. This study describes an economic storage model which enables the user to identify the most economic utilization of one specific cavern storage site. Salt caverns represent the most flexible large-scale geological storage. Currently, salt caverns are mainly in use as seasonal gas storage. Europe offers a high potential for further cavern storage use. The model includes technical properties of salt caverns as storage facilities, and hydrogen, compressed air, methane and carbon dioxide as storage media. Real options analysis is used to value the stored medium during the lifetime of the cavern storage. The model suggests, based on the expected market development, the most attractive storage medium to maximize the overall earnings. Potential storage costs for each application are compared with economic gains or cost savings (e.g. avoided carbon tax, revenues from peak-load sale of electricity, etc.) which are generated by an optimal time-dependent usage of the stored medium. The simulation results show that the estimated storage costs both for the natural gas storage as well as the CAES exceed the discounted revenues in the base variant. On top of that, the value of intertemporal arbitrage of carbon dioxide is not enough to cover the marginal costs.
10:45-12:00 Track II
Competition & Strategy
Chairperson: Richard Ruble (EMLYON Business School, France)
Never Make a Move Too Soon: Commitment and Flexibility in Staged Investment
Richard Ruble (EMLYON Business School, FR)
Discussant: Maria Lavrutich (Tilburg University, NL)
The benefit of strategic commitment and the option value associated with flexibility are jointly examined. A first-mover optimally splits a discrete investment into two distinct parts, with a first installment that positions the firm strategically and a contingent remainder that accounts for both risk and simultaneous competition. The benefit of commitment outweighs the opportunity cost of forgone flexibility for a broad range of cost shocks. Thus, a first-mover will seek to sink a part of its capacity cost early knowing either that it may subsequently adjust capacity if economic conditions turn out to be favorable or that its partial investment will enable it to preempt a potential rival more effectively.
Strategic Investment and Acquisitions in a Duopoly Patent Race
Rujing Meng (University of Hong Kong, HK), Albert Kyle (University of Maryland, US)
Discussant: Richard Ruble (EMLYON Business School, FR)
This paper uses a continuous-time real-options patent-race model to study a patent-race game in which a firm with larger research bandwidth competes with a firm with smaller bandwidth. The large firm can make strategic acquisitions or investments in the small firm subject to transactions costs. Acquisitions occur when the small firm is about to make pre-emptive investments or the large firm has set-backs and the two firms are about to enter head-to-head competition. Strategic investments tend to occur when the smaller leader has technological setbacks. Our continuous-time approach shows that some rich strategic play can occur.
Predatory Pricing in a Duopoly under Financing Constraints: Using Cash as War Chest
Maria Lavrutich (Tilburg University, NL), Jacco Thijssen (University of York, GB)
Discussant: Rujing Meng (University of Hong Kong, HK)
In this paper we develop a stochastic dynamic model of predatory pricing. When profits evolve stochastically, a negative demand shock can lead to bankruptcy for firms, which cannot immediately raise external capital. An assumption that firms are able to hoard liquidity creates incentives for market incumbents to use the predatory pricing strategies in order to keep the new players out of the industry. Applying game theoretic and dynamic programming techniques, we show that an incumbent firm may use a large cash reserve as a war chest to initiate a price war that could drive the entrant out of the market. Because of uncertainty the entrant may wish to take a chance and enter based on the probability of success. Therefore, realised market structure may be different for different sample paths of the stochastic process.
12:00-2:00 Luncheon
2:00-3:15 Track I
Shutdown & Replacement Decisions
Chairperson: Dean Paxson (Manchester Business School, GB)
Nordic Nugget: Mossin and Dixit Mothballing Models
Dean Paxson (Manchester Business School, GB)
Discussant: Deok-Joo Lee (Kyung Hee University, KR)
Forty years ago Mossin published the first real option scale model leading to other exit/entry models. Several aspects of this model are explored, along with the Dixit (1988) recast in continuous time. Both approaches present interesting challenges for future research.
Valuing Replaceable Deteriorating Assets
Roger Adkins (University of Bradford School of Management, GB), Dean Paxson (Manchester Business School, GB)
Discussant: Yuri Lawryshyn (U. of Toronto, Canada)
We focus on the time-varying real option value (ROV) of replaceable assets whose operating cost and salvage value deteriorate stochastically. As the operating cost approaches the threshold justifying an immediate replacement, the ROV increases while the net present value of the operating asset declines. The ROV increases with the number of replacement opportunities, with large salvage values and volatile operating costs, possibly enhancing the equity value for those replaceable asset owners. Use of similar one or two factor models may undervalue replaceable assets, possibly misleading investors and corporate decision makers.
Optimal Strategy for Equipment Replacement: An Application in Korea
Deok-Joo Lee (Kyung Hee University, KR), Sung-Joon Park (Knowledgworks, KR), Kyung-Taek Kim (Kyung Hee University, KR)
Discussant: Roger Adkins (University of Bradford School of Management, GB)
Optimal equipment replacement is one of the important problems in engineering economy. Traditionally the economic life of equipment which can be calculated on the basis of discounted cash flow methodology has been regarded as a fundamental solution concept of the optimal equipment replacement problems. However it has been frequently pointed out that the concept of the economic life of equipment based on the discounted cash flow has a critical weakness such that it cannot consider uncertain factors which would affect the decision making of equipment replacement. The present paper proposes a new model of optimal equipment replacement under uncertainty by which the economic life of equipment considering technological and economic uncertainties can be calculated using real option approach. Furthermore we applied the model to determine the economic life of the public medium and large sized research equipment in Korea. In this empirical application, the real option methodology is used to consider the uncertainty of R&D projects and the models considered the discontinuous advancement of research equipment technologies in finite spans. According to the results of empirical analysis, it is found that if the uncertainty of R&D projects is high, the life cycle of research equipment will vary greatly, which indicates that our models are suitable for highly uncertain R&D environments. These models and analysis results seem to be helpful to institutions that need to calculate replacement periods in relation to the deterioration of research equipment.
2:00-3:15 Track II
Option Games Applications I
Chairperson: Paulo J. Pereira (U. of Porto, Portugal)
Deciding on Greenfield Investment or Acquisition of a (Hidden) Competitor
Paulo J. Pereira (University of Porto, PT), Elmar Lukas (Otto-von-Guericke-University, DE)
Discussant: Michael Flanagan (Manchester Metropolitan University, GB)
In this paper we extend the literature on real options under hidden competition. In addition to the decision of investing or waiting, we consider the realistic alternative of acquiring the hidden rival, after his appearance in the market. The model that supports the decisions regarding the timing, the best alternative available, as well as the optimal scale for the project is derived. We also introduce and analyze the conditions under which an acquisition is preferable to the greenfield investment, which can be useful for supporting the decision making in real world.
Strategic Market Entry with Production Flexibility in Oligopoly
Benoit Chevalier-Roignant (BCR, FR), Christoph Michael Flath (JMU Würzburg, DE), Lenos Trigeorgis (University of Cyprus and King's College, CY)
Discussant: Paulo J. Pereira (School of Economics and Management, University of Porto, PT)
We model an oligopoly whereby several firms may enter a market in the future competing with invested rivals in quantity. In this two-stage dynamic Cournot model, firms have production flexibility to set output given stochastic demand while facing capacity constraints. Early market entry decisions by rivals give rise to a coordination problem among would-be entrants. We characterize the Markov Perfect Equilibrium and derive the value of the investment showing that value is no longer monotone increasing and convex but exhibits “competitive waves.”
Buy-to-Let Tax Policy: UK Landlord Strategic Default and Negotiation Options
Michael Flanagan (Manchester Metropolitan University, GB), Dean Paxson (University of Manchester, GB)
Discussant: Benoit Chevalier-Roignant (BCR, FR)
We extend the commonly valued strategic default option by proposing and developing a strategic renegotiation option, where we assume an instantaneous renegotiation between a lender and a UK landlord triggered by a declining rental income. We ignore the prepayment option given that UK interest rates are unlikely to lower in the medium term. We then investigate how a reduction in mortgage tax relief might differentially affect the optimal acquisition threshold and the exercise of the default or renegotiation options. We model the renegotiations by considering the sharing of possible future unavoidable foreclosure costs in a Nash bargaining game. We derive closed form solutions for the optimal loan terms, such as LTV (Loan To Value) and the coupon offered by the lender to a landlord. We demonstrate that the ability of either party to negotiate a larger share of unavoidable foreclosure costs in one’s favour has a significant influence on the timing of the optimal ex post negotiation decision, which will invariably precede strategic default. A reduction in tax relief for interest payments has significantly different effects, contingent on option type, on investment entry and exit (default or negotiation) as well as on the appropriate LTV and coupon offered to the landlord by the lender.
3:15-3:45 Afternoon Coffee Break
3:45-5:00 Track I
Empirical Evidence: Firm Growth & Performance
Chairperson: Lenos Trigeorgis (U. of Cyprus & KCL)
Real Options-based Industry and Firm-level Effects on Firm Performance
Olubanjo Adetunji, Akintola Owolabi (Pan-Atlantic University, NG)
Discussant: Luca Del Viva (ESADE Business School, ES)
This paper provides empirical evidence for the relative importance of industry and firm-level factors as determinants of firm performance using real options theory. It argues that the key industry and business-specific factors identified in the industrial organization and strategic management literatures are real options and the effects of these variables on firm performance may be due to real options embedded in these factors. The paper thus uses real option framework to further investigate the relative importance of industry and firm-level effects on firm performance. The real options measures in the factors are identified and their effects on firm performance are also analyzed. The paper therefore further extends the literature on real options by presenting evidence for the effects of real options and option-like strategic investments on firm performance. The study uses the financial and other organization-specific data of firms listed on the Nigerian Stock Exchange
Growth Options, Incentives, and Pay-for-Performance
Sebastian Gryglewicz (Erasmus University Rotterdam, NL), Barney Hartman-Glaser (UCLA, US)
Discussant: Olubanjo Adetunji (Pan-Atlantic University, NG)
When firm value is non-linear in manager effort, pay-for-performance, measured as the sensitivity of manager compensation to firm value, is not a sufficient statistic for the strength of managerial incentives. To show this, we characterize the optimal contract between an investor and a risk-averse manager in the presence of a lumpy investment option. In the simplest version of our model, increasing the size of the growth option decreases pay performance sensitivity while leaving managerial incentives unchanged. While increasing the size of the growth opportunity increases the convexity of the value function with respect to firm productivity, it does not increase the sensitivity to output of the manager's pay necessary for incentives. In more general specifications of our model, the manager's incentives can depend on the size of the growth option as well as other parameters. In this case, the effect of the severity of the moral hazard problem on pay-for-performance can have the opposite sign as that on the manager's incentives. Empirically, we show that a one standard deviation increase in Book-to-Market, a proxy for the presence of growth options, leads to roughly 6.5% increase in Jensen's (1990) pay performance sensitivity, as measured by dollar changes in manager wealth to dollar changes in firm value. This effect is consistent with our theoretical finding that pay performance sensitivity is decreasing in the size of growth options.
Related Stock Market Anomalies: Growth, Distress and Skewness
Luca Del Viva (ESADE Business School, ES), Lenos Trigeorgis (University of Cyprus and King's College London, CY), Nophytos Lambertides (Cyprus University of Technology, CY)
Discussant: Sebastian Gryglewicz (Erasmus University Rotterdam, NL)
We examine how various stock market anomalies are related, namely whether the skewness effect is related to the value/growth anomaly, the asset growth effect, the volatility effect, and the distress risk puzzle. We posit that firm growth and downsizing/reorganization options lead to more convex value payoffs and increased skewness. We find the part of expected idiosyncratic skewness that can be predicted using only measures of asset growth (in interaction with volatility), growth options and distress is negatively related to expected returns, while the other part is not priced. We conclude that the negative relations between asset growth, growth options and distress risk with stock returns can be attributed to the more positively skewed return distribution for growth-oriented and distressed firms.
3:45-5:00 Track II
Options Games and Other Applications
Chairperson: Jacco Thijssen (U. of York, UK)
Be Quick or Persistent? Feedback Effects between First and Second Mover Advantages in Switch Markets
Jacco Thijssen (University of York, GB), Jan-Henrik Steg (University of Bielefeld, DE)
Discussant: Maximilian Schreiter (HHL Leipzig GSM, DE)
We analyse a dynamic model of investment under uncertainty in a duopoly where firms have an option to switch from one market to another. We construct a subgame perfect equilibrium in Markovian mixed strategies and show that both preemption and attrition can occur along typical equilibrium paths. This changes the nature of stopping problems to be solved, compared to existing strategic real option models. Equilibrium outcomes differ qualitatively from those of the model’s deterministic version. Competition endogenously determines the firms’ exposure to the two markets’ risk factors, one of which is indeed eliminated by the mixed strategies in equilibrium.
Funding Entrepreneurial Investment Options under Adverse Selection and Moral Hazard
Gijsbert Zwart (University of Groningen, NL)
Discussant: Jacco Thijssen (University of York, GB)
We analyze optimal financing of an entrepreneur's real option investment when investors do not observe the stochastic quality process driving the investment's value. Optimal contracts encourage entrepreneurs to postpone investment by paying them for waiting. When there is adverse selection on initial quality, high quality entrepreneurs invest inefficiently early to signal their type. In the presence of moral hazard, paying before investment reduces entrepreneur incentives to work, and in response, also in this case the optimal contract induces early investment.
Corporate Financing Policy, Debt Redemption and Default in Leveraged Buyouts
Maximilian Schreiter (HHL Leipzig GSM, DE), Alexander Lahmann, Bernhard Schwetzler (HHL Leipzig GSM, DE)
Discussant: Gijsbert Zwart (University of Groningen, NL)
We analyze corporate financial policies in leveraged buyouts (LBOs) in the presence of default risk. Our model captures the LBO-specific stepwise debt reduction, either with predetermined or cash-flow dependent (cash sweep) principal payments, and thus allows for dynamic redemption. These dynamics imply stochastic, discontinuous default boundaries. Our framework enables us to derive explicit-form solutions for the net present value (NPV) and the internal rate of return (IRR) of an LBO investment. We show that in scenarios with high entry debt and high redemption payments, the flexibility associated with dynamic redemptions creates value for investors, while fixed redemptions yield higher NPV and IRR values for moderate redemption due to lower debt yields. Moreover, we discuss optimal corporate financial policies implied by NPV or IRR maximization and find that the latter always results in increased leverage with higher default probability. The model of piecewise linear boundaries developed in this article is sufficiently flexible to be applied to a wide range of problems in corporate finance.
5:00-5:40 Academic Keynote Address
Capacity Choice in (Strategic) Real Options Models
Peter Kort (Tilburg U., NL)
7:00-9:00 Gala Dinner
Sponsored by Research Council of Norway, NTNU and CenSES
Day 3 – Saturday, June 17 (Trondheim)
9:00-10:15 Track I
Contractual Options & Guarantees
Chairperson: Luiz Brandão (PUC-Rio, Brazil)
Contractual Win-win Option Positions: Application of Customized Assets in the Oil Sector in Brazil
Luiz Brandão, Rodrigo Silva (PUC-Rio, BR), Carlos Bastian-Pinto (IBMEC-RJ, BR)
Discussant: Alcino Azevedo (University of Hull, PT)
An agent with a short position in a call option typically assumes a contingent liability where the optimal exercise of this option by the buyer entails a loss for this agent. However, we show that there may be situations where the optimal exercise by the agent who is long on the options is also optimal for the agent with the short position, which apparently violates traditional practice. In this article we analyze the reasons for this apparent discrepancy and illustrate with a real case of an asset in the oil sector under the real options approach. This apparent violation of law of one price, which is a cornerstone of modern financial theory, can be justified in the case of customized real assets, which may have a different value for each party. Unlike freely traded financial assets, real assets can exhibit this behavior because of incomplete information, patent protection, asymmetrical synergies or by force contractual clauses. In this case, unlike traditional behavior where the agent who is short the option assumes a contingent liability, the optimal exercise of the option by the agent who is long the option is also optimal for the agent who is short the option as this exercise represents additional project cash flows at the end of the original contractual period.
Infrastructure Investment with Real Collar Options: Revenue Guarantees and Ceilings
Roger Adkins (University of Bradford, GB), Dean Paxson (Manchester Business School, GB)
Discussant: Luiz Brandão (PUC-Rio, BR)
We provide a general model for investment in a project with permanent downside revenue guarantees accompanied by permanent upside revenue ceilings. Analytical solutions for perpetual American call and put options are well established in the real options literature, but not necessarily viewed as reflecting barriers for an infrastructure investment. We show the sensitivities of some standard real collar options, with the effect on both thresholds and real option values of changes in the reflecting barriers, the volatility of revenues, revenue drifts, and interest rates. Finally, we consider both the sudden imposition of revenue ceilings, or withdrawal of revenue guarantees on the investment opportunity thresholds and real option values.
Non-Competition Covenants in Employment Contracts with Litigation Uncertainty
Alcino Azevedo (University of Hull, PT), Paulo Pereira (University of Porto, PT), Artur Rodrigues (University of Minho, PT)
Discussant: Roger Adkins (University of Bradford, GB)
This paper presents a real options model which evaluates the effect of the use of non-competition covenants on employment agreements. It applies to cases where firms want to protect their business confidential information from former employees, whose departure raises the threat of unfair competition. Among other results, we find that the time period of the covenant as well as the value of the manager's compensation play a very important role on the behaviour of both the firm and and manager, and that there is an infinite number of pairs "time period of the covenant $versus$ employee's compensation", which align the interests of the manager with those of the firm.
9:00-10:15 Track II
Innovation & Investment Timing
Chairperson: Arkadiy Sakhartov (Wharton School, U. of Pennsylvania, USA)
Valuing Early Stage Investments with Market Timing Risk
Yuri Lawryshyn (University of Toronto, CA), Matt Davison (Western Ontario University, CA)
Discussant: Josef Schosser (University of Passau, DE)
In this work, we build on a previous real options approach that utilizes managerial cash-flow estimates to value early stage project investments. The model is developed through the introduction of a market sector indicator, which is assumed to be correlated to a tradeable market index, and is used to drive the project's cash-flow estimates. Another indicator, assumed partially correlated to the market, is used to account for timing risk. This provides a mechanism for valuing real options of the cash-flow in a financially consistent manner under the risk-neutral minimum martingale measure. The method requires minimal subjective input of model parameters and is very easy to implement. Furthermore, we couple simulation with the results of our model to provide managers with a visualization of potential outcomes.
Technology Adoption and Investment under Risk Aversion and Rivalry
Lars Sendstad (NHH, NO), Michail Chronopoulos (University of Brighton, GB)
Discussant: Yuri Lawryshyn (University of Toronto, CA)
As a product of research and development (R&D), technological innovations are subject to frequent upgrades. Consequently, a firm typically does not hold a single but rather a sequence of investment opportunities, and, as a result, it must determine both the optimal technology-adoption strategy, and, within each strategy, the optimal investment policy. Although investment is typically deferred as both price uncertainty and the level of risk aversion increase, the presence of a rival hastens investment. Here, we examine these opposing effects in a duopoly setting under price and technological uncertainty.
Time (In)consistent Behavior and Investment Timing
Josef Schosser (University of Passau, DE)
Discussant: Lars Sendstad (NHH, NO)
If decision makers have exclusive rights to particular investment projects, they frequently have the opportunity to delay these investments. This paper analyzes the effect of quasi-hyperbolic discounting, i.e. time-inconsistent preferences on the exercise timing of such options to defer an investment. It complements earlier work on this issue covering risk aversion and capital market interaction. The results are as follows: In a number of cases, the capital market environment provides for the irrelevance of quasi-hyperbolic discounting. Besides this, a different behavior of time-inconsistent and time-consistent decision makers occurs only forquite specific parameter conditions. In light of experimental evidence for time-inconsistent behavior, this provokes the following question: Is time- inconsistent behavior really driven by quasi-hyperbolic discounting, but rather by more fundamental irrationality (like a disregard of fairly ubiquitous market pportunities)?
10:15-10:45 Morning Coffee Break
10:45-12:00
Entrepreneurship, Innovation & Infrastructure Decisions (Best Student Papers Session)
Chairperson: Afzal Siddiqui (University College, London, UK)
Entrepreneurial Financing Decisions and Contingent Payment Mechanisms
Miguel Tavares Gärtner (CEF.UP and University of Porto, PT), Paulo Jorge Pereira, Elísio Brandão (University of Porto, PT)
Discussant: Linda Salahaldin (Telecom Ecole de Management, FR)
We discuss how Contingent Payment Mechanisms (also known as Contingent Earn-Outs) enable of Entrepreneurial Financing decisions. First, we introduce a taxonomy of contingent payment mechanisms, by combining features regarding their term and amount. Second, we introduce each of these alternative mechanisms on a previously developed real options framework for analyzing Entrepreneurial Financing decisions, in which one wealth constrained Entrepreneur is looking for an external equity provider – taken as a Venture Capitalist – to support a given growth strategy. We conclude that different contingent payment mechanisms are equivalent in obtaining joint support from Entrepreneurs and Venture Capitalists regarding optimum investment timing and, therefore, that the choice on the optimum mechanism to use depends on variables which are exogenous to the model, such as liquidity preferences or constraints, timing requirements, post-deal integration or overall deal terms.
Innovation and Optimal Timing of Technology Adoption: War of Attrition vs. Preemption Games
Nick F.D. Huberts (Tilburg University, NL)
Discussant: Miguel Tavares Gärtner (CEF.UP and University of Porto, PT)
This paper considers two incumbent firms with an option to adopt a horizontally and vertically differentiated technology. The firms engage in a Stackelberg competition where they decide upon both the investment moment and the investment size. I find that a war of attrition arises when the degree of innovation is small, but when the products are sufficiently horizontally differentiated. Otherwise the firms end up in a preemption equilibrium. When a second-mover advantage is present, firms either want to stay alone on the old market or want to set a larger capacity as Stackelberg follower. This paper also shows that market uncertainty increases the first-mover advantage while at the same time it makes it more attractive for the endogenous follower to forego investment.
Strategic Investment Decisions in Mobile TV Infrastructure: Real Options and Coalition Games
Linda Salahaldin (Telecom Ecole de Management, FR), Amal Abdel Razzac (Institut Mines Telecom, Telecom SudParis, FR), Salah Eddine ELAYOUBI (Orange Labs, FR), Tijani Chahed (Institut Mines Telecom, FR), Yezekael Hayel (University of Avignon, FR)
Discussant: Nick F.D. Huberts (Tilburg University, NL)
This work presents a strategic investment framework for mobile TV infrastructure. We address the question of whether an operator should enter the mobile TV market and, if yes, when to do so. We consider a realistic setting where the mobile TV network is mainly relying on a DVB infrastructure whose coverage can be complemented by the cellular network. As several actors may be involved in this service setting, we consider a dynamic game theoretical framework combining real option theory with coalition games. We consider two main sources of uncertainty: user demand and network operation cost. We then propose a novel a bi-level dynamic programming algorithm that solves the underlying maximization problem. Our numerical results illustrate the decisions of both actors and the impact of the system parameters and the degree of uncertainty on the investment dates.
12:00-1:00 Panel Discussion
Current State, Challenges and Future Prospects
Moderators: Dean Paxson (Manchester Business School, UK) and Luiz Brandão (PUC-Rio, Brazil)
Panelists Include:
Stein-Erik Fleten (NTNU, Norway)
Kuno Huisman (Tilburg U, Netherlands)
Yuri Lawryshyn (U. of Toronto, Canada)
Diderik Lund (U. of Oslo, Norway)
Artur Rodrigues (U. of Minho, Portugal)
Arkadiy Sakhartov (Wharton School, U. of Pennsylvania, USA)
Afzal Siddiqui (University College London, UK)
Jacco Thissen (U. of York, UK)
Elizabeth Whalley (U. of Warwick, UK)
1:00 Best Student Paper Award & Closing Remarks
1:10-1:40 Coffee
2:00-6:00 pm Boat Trip at Munkholmen Island (1.3 km)
Conference Concludes
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