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Program 2017

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Annual International Conference on Real Options: Theory Meets Practice

Day 1 - Thursday June 29, 2017

9:00 - 10:15 TRACK I (Managerial)

Managing Ventures

Chairperson: Carlos Bastian-Pinto (IBMEC, Brazil)

Flexible Equity for Service Contracts in Venture Capital Deals: Bringing Together Early Stage Companies and Investors

Igor Monteiro (PUC-Rio, BR)

Luiz Brandão (PUC-Rio, BR)

The participation of financial advisory firms in Venture Capital deals is rare due to the budgetary constraints that are typical of early stage companies, which does not allow them to pay retainer fees for the services rendered. From the advisor´s perspective, the deal is unattractive, as the success fee may not be large enough to reach the expected return or even to cover the fixed costs involved in prepping and working out the deal. Without a professional support for the deal, in general it is the own startup´s entrepreneur who is the responsible for leading the company roadshow and investment round, even though he or she may not have the financial and negotiation skills required for the task. We suggest a contracting model that may help bring together financial advisory firms and early stage companies by introducing more flexible forms of payment, which we call “equity for service”, involving a discount for the conversion, synergy gains, and a valuation guarantee. Our results show that this financial toolkit may help bridge this gap in Venture Capital deals, making the participation of professional financial companies profitable for all parties involved.

Startup Valuation: An Application in Brazil

Mareclo Lewin (UFRJ / COPPEAD, BR)

Carlos Bastian-Pinto (Ibmec Business School, BR)

The article evaluates a newborn company with high growth potential exposed to an extremely volatile environment. A Brazilian startup company was used to valuate the real options included in the varied stages of growth and life cycle. The model contributes to the relationship between entrepreneurs and investors with respect to the negotiation of the uncertainties in business deals. The Monte Carlo Simulation and the Binomial Decision Tree were used in this construction to map the project’s flexibilities and risks. The traditional Discounted Cash Flow was used as the underlying asset wherein the real options volatilities were applied. The result was an expanded valuation of the case asset, where the value of the main uncertainties was added. Finally, displacing from the negotiation of the discount rate the liability of carrying the overhead of the project’s main risks.

Artificial Intelligence, Machine Learning and Market-based Econometrics for Flexible Decision Making

Gill Eapen (Stout, US)

As data in the enterprise increase exponentially, it is imperative that organizations find better ways to utilize data and appropriate analytics to reduce cost and time expended in repeating processes. With a plethora of analytical techniques, hyped-up terminology and many companies offering products and services, it has become difficult to ascertain what could be useful. Most make ROI claims but seldom deliver. More importantly, to reduce cost and time in financial processes, a thorough understanding of business processes is required before applications of any type of analytics or technology. We address how organizations can cut through the clutter and confusion created by the latest wave of technology and analytics, accompanied by machine learning, deep learning and artificial intelligence for better decisions. Using case studies, practical examples and a machine learning technology, we show how machine learning combined with market-based econometrics can substantially improve decision quality and reduce time and cost. We demonstrate how human resource intensity can be significantly reduced in financial processes with associated reductions in total cost, errors and rework.

9:00 - 10:15 TRACK II (Academic & Managerial)

Resources & Infrastructure

Chairperson: Marco A.G. Dias (PUC-Rio, Brazil)

The Choice of Stochastic Process in Oil Prices

Arthur Felipe Tavares do Poço (Ibmec Business School, BR)

Luiz Magalhães Osorio (Ibmec Business School, BR)

Carlos Bastian-Pinto (Ibmec Business School, BR)

Oil is a commodity that has very important role in a modern economy, generating the interest for its price behavior. Furthermore, there are many assets – oil derivatives, production assets, financial derivatives, contracts, etc. – whose values are linked to this commodity performance. In this sense, the choice of stochastic processes in order to represents the oil prices behavior will have significant impact not only in the value of this assets, but also in there optimal investment decision rules. Considering the different models presented by several previous works, the aim of this study is to evaluate, using statistical tools which model could be more appropriate among existing propositions.

Portfolios of Correlated Oil Exploration Prospects with Learning, Sequential and Defer Options

Marco Antonio Guimarães Dias (PUC-Rio, BR)

Luigi de Magalhães Detomi Calvette (Petrobras, BR)

In this article we consider the interaction of three different options: the learning option, the sequential option and the defer option for portfolios of two and three correlated prospects. We consider uncertainty about the petroleum existence (technical uncertainty) and long-term oil price uncertainty (market uncertainty). In contrast with the traditional exploratory economics, it could be optimal to drill a prospect with negative expected monetary value (EMV) if there are correlated prospects so that there are learning options embedded when drilling a prospect. In addition, we saw that the drilling order matters even when the prospects have the same EMV and the same NPV in case of success. Even more, may be optimal to prioritize (drilling first) prospects with lower EMV, so that the optimal exploratory prospects portfolio ranking can be very different of traditional exploration economics. Decisions as to drill the prospects immediately or to wait for a better price scenario were also addressed using the multi-period binomial to model the oil price uncertainty. With each prospect order being an alternative, we find disconnected exercise regions with intermediate waiting regions, resembling real options models of choice between discrete scale alternatives.

Highway Pavement Residual Risks in Public-Private Partnerships

Yuanshun Li (Ryerson U., CA)

Xianxun Yuan (Ryerson U., CA)

To understand the residual value risks in public-private partnerships, we decide to conduct a real option analysis on the residual value risk. In this study, we identify two types of real options, the initial construction option and the maintenance option. The values of these options are estimated using least square Monte Carlo method to demonstrate the potential benefit of using the P3 model. We find that under the P3 model, the private firms are more likely to explore the option values and achieve better asset performance, which will ultimately be translated into residual value and passed on to the public through proper contract design. Under the P3 model, private firms are more likely to explore these option values because their profit maximization function is integrated over the entire 30 years. Under the PSC model, private firms tend to be myopic and less likely to explore the real option values because their profit maximization function is constructed over a much shorter period of time which may or may not allow them to collect all the future benefits of the strategic investments in the initial construction or the maintenance program.

10:15 - 10:45 Morning Coffee Break

10:45 - 12:00 Track I (Managerial)

Infrastructure Investing & Public Policy

Chairperson: Luiz Brandão (PUC-Rio, Brazil)

Investing in Electricity, Gas and District-Heating Infrastructure: An Application for a Multi-Utility in Switzerland

Wolfgang Korosec (St. Galler Stadtwerke, CH)

Karl Frauendorfer (U. of St. Gallen, IORCF, CH)

In this paper, we describe a method, which can be applied by practitioners to optimize the investments in distribution grids for electricity, gas and district heating of a multi-utility. We propose a combined, structured approach to reduce the level of uncertainty by applying research synthesis and meta-analysis methods to relevant information sources, scenario-planning and the linking of spatial data with technical and financial information owned by an energy provider. Infrastructure development projects are modeled as compound real options and evaluated using a fuzzy pay-off method.

Valuing a Private Public Partnership (PPP) in Public Lighting

Rodrigo Secca (Ibmec Business School, BR)

Carlos Bastian-Pinto (Ibmec Business School, BR)

Luiz Ozorio (Ibmec Business School, BR)

Luiz E. Brandao (PUC-Rio, BR)

Efficient public lighting can result in multiple benefits to society: energy savings, reduction in environmental footprint as well as better street security. New technologies of great impact in this field, such as LED and smart grid, are offering the opportunity of significant efficiency gains to many cities in the world. On the other hand, most emerging economies are currently facing significant budget constraints and one of the shortcuts to fill this investment gap in the sector has been the use of Public Private Partnerships (PPPs) by municipalities. However, as the cost of energy is highly volatile, the options offered by the government in the bidding processes may not be correctly identified and valued if a dynamic approach, as the Real Options Theory, is not considered. In this work, we analyse one real case of a PPP in public lighting in Brazil, exposing the value of the flexibility and energy price uncertainty, comparing it to the traditional static approach.

The Effectiveness of Migration Policy Decisions: A Case Study on Forced Migration in the 2015 European Migration Crisis

Linda Peters (U. of Belgium, BE)

This paper demonstrates how real options analysis could be used by migration policy makers in order to quantify the effectiveness of their decision-making. This is illustrated on the basis of a case-study on forced migration during the European migration Crisis of 2015. The choice for a specific transit migration route is modeled as an investment using a growth option model. From this model, we show how policy makers can intervene pro-actively, by influencing the incentives for refugees in their decision-making to choose for a certain route. This paper demonstrates the added value of real options by applying this framework to global public policy and provides insight into the reasons for the gap between theory and practice.

10:45 - 12:00 TRACK II (Academic & Managerial)

Acquisition & Collaboration

Chairperson: John Kensinger (U. N. Texas)

Valuing the Acquisition of a New Business under Ambiguity: A Case Study in Japan

Yuta Fukui (Keio U., JP)

Junichi Imai (Keio U., JP)

This study picks up an existing company and conduct a case study with respect to a new business for the company. In this case study, we observe that the company is starting a membrane ceilings business in addition to the existing business; sales of iron. In the paper, we apply the real option approach to the actual business and evaluate it. We provide valuable implication with regard to the managerial decision under uncertainty. In addition to the standard option pricing theory, we also take model risk into account. For this reason, we take the parameters of the model as random variables. It enables us to examine the effect of the ambiguity on the optimal decision for the company. In order to analyze the actual business, we develop a systematic approach in analyzing managerial flexibility under uncertainty. The approach includes specifying important risk factors, parameter estimation, handling the ambiguity, and deriving the optimal strategy. Our analysis reveals that the company has two real options under uncertainty with respect to a market price and demand. We show that the options have a significant impact on the project value of the membrane ceilings. We also show that the presence of the model risk could change the optimal managerial decision when to expand the new business.

Dynamic Hybrid Patent Strategies: Fight or Cooperate?

Francesco Baldi (Luiss "Guido Carli" U., IT)

Lenos Trigeorgis (MIT Sloan School of Management, King's College London and U. of Cyprus, CY)

We address a research gap at the interplay between competition and cooperation in the context of patent strategies. We advocate a dynamic notion of strategy involving a menu of patent strategies enabling the firm to switch among compete, cooperate or wait (patent sleep) modes. We examine the optimality of different strategies based on contingencies related to industry demand and dynamism and whether innovation is radical or incremental, identifying the circumstances under which strategic patenting is best used to compete or to cooperate. Dynamic hybrid strategies obtain, involving switching from one type of compete mode to another or from competition to cooperation as demand rises or as the innovation advantage gets small. In high demand initially give-up strategies may switch to competing and then, at higher demand l, to cooperation. In contrast to disruptive technologies, a dynamic switch can occur in either direction and is more valuable in a more uncertain environment.

Analyzing the Collaboration Network of Real Options Authors

Hernandes Fagundes (UENF, BR)

Rodrigo Nogueira (UENF, BR)

Bibliometrics is a powerful tool to obtain scientific production data, with applications in a wide range of knowledge fields. When the data visualization and analysis, due complexity, requires techniques that are more advanced, the Graph Theory application provides a great benefit. This study develops bibliometric methods in association with the Graph Theory to construct and analyze the collaboration network among Real Options Articles Authors in a world scale and pointing out Brazilians particulars. The paper concludes that the existent network is complex and notices the occurrence of various isolated communities, which are inwardly well connected. Few professionals compose most of these groups, but it was possible to identify a giant component joining 11% of the world researchers.

12:00 - 2:00 Luncheon

2:00 - 3:15 TRACK I (Managerial)

Resources & the Environment

Chairperson: Gordon Sick (U. of Calgary, Canada)

Smart Well Technology: Information Acquisition and Flexible Management under Uncertainty

Ana Carolina Abreu (PUC-Rio, BR)

Marco Antonio Guimarães Dias (PUC-Rio, BR)

Marco Aurélio C. Pacheco (PUC-Rio, BR)

Alexandre Emerick (Petrobras, BR)

Felipe Coelho (PUC-Rio, BR)

Smart well, or intelligent well completion, is an oilfield development technology operated remotely from the platform that, in real time, monitor (bottom-hole sensors) and control (bottom-hole valves) oil/gas/water production and water/gas injection by reservoir zone. Although more expensive, this well technology enables the acquisition of relevant information (learning option) and inject flexibility in the development plan because we can manage (exercise options) to open or close the downhole valves in response to new geological information arriving continuously during the oilfield life. The valuation of smart well technology shall consider the geological and market uncertainties as well as the technology reliability. This complex investment under uncertainty problem, in which information acquisition and flexibility are the primary sources of value, demand sophisticated methods of optimization under uncertainty. In this paper, we describe the valuation of this flexibility using a new decision support system under development called FlexWell. The main FlexWell goal is to assist the experts in drawing up reservoir development plans with smart wells, valuating the benefits from the extra flexibility provided by a more capital intensive technology. FlexWell’s methodology is based on approximated dynamic programming (Powell, 2011), which reduce the computational burden, and on reservoir simulation, to evaluate the flow control strategy for smart wells management over various possible reservoir scenarios. The smart wells investment attractiveness rises with the volatile oil price. Here we consider the oil price uncertainty in a conceptual real options model to decide between the cheaper traditional completion and the more expensive intelligent completion investments. The main inputs for option model come from the FlexWell, so that both level of real options values are integrated.

Innovation Framework for Real Options Adoption in the Mineral Industry

Kwasi Ampofo (U. of Queensland, AU)

This paper: 1. constructs an innovation framework based on the works of Everett Rogers in Diffusion of Innovations (2003) and Eliyahu Goldratt and Jeff Cox in The Goal (2004), 2. addresses the challenges associated with the bottlenecks in the application of ROA and 3. discusses practical ways of making ROA compatible with and less complex for mineral operations.

Application of Real Option Methods for Emission Abatement Investments

Carmen Mayer (Karlsruhe Institute of Technology, DE)

Frank Schultmann (Karlsruhe Institute of Technology, DE)

Real option analyses are broadly discussed in economics and finance and multiple application examples have been published over the last centuries. Different calculation methods for option values have been presented and successfully implemented in theoretical case studies and practical applications. Especially in application-oriented publications, however, there is often no detailed explanation, why a specific calculation method has been chosen and which effects this may cause regarding the results as well as the transparency and practicability of the method. Therefore we will present a brief overview of the type of applications we consider - investments in emission abatement investments for large industrial plants, typically of the energy, steel or chemical sector. These investments have some specific characteristics, most importantly they are usually not economically reasonable as they do not generate noteworthy revenues, but are enforced by political regulations. We will discuss how the specific features and assumptions can be “translated” in the financial language of option valuation. Afterwards, an overview of the most relevant option valuation methods will be provided, considering analytic, numeric and stochastic approaches. Finally, the applicability of the considered approaches to the above mentioned type of investment decisions is assessed and possible influences on results and implementation are derived thereof from a methodology oriented perspective. For the considered application, the stochastic simulation method “Least Squares Monte-Carlo-Simulation” extended by the “Exercise Boundary Parameterization Approach” seems a very promising approach due to its flexibility and the distinct deduction of a stopping rule for American options.

2:00 – 3:15 TRACK II (Academic & Managerial)

Empirical Evidence

Chairperson: Lenos Trigeorgis (U. of Cyprus, King's College London & MIT)

Buy-and-Build Serial Acquisitions: Theory and Evidence

Han Smit (Erasmus U. Rotterdam, NL)

Dyaran Bansraj (Erasmus U. Rotterdam, NL)

This article aims to advance theory and presents evidence on acquisition strategies by determining the optimal conditions when private equity investors execute buy-and-build serial acquisitions. Building on real options and game theory, our theory for buy-and-build provides new insights into the optimal industry conditions (e.g., available acquisition options), company conditions (size, improvability, availability and affordability) and financing conditions (value uncertainty) and the dynamic interactions between these conditions. Consistent with our theory, we empirically confirm that the availability of platform, follow-on, and exit options are related to a higher probability of buy-and-build strategies to occur. We find that targets of these strategies are improvable, sizeable, and available and affordable and that sufficient financial resources and the positive resolution of valuation uncertainty drives the exercise of these acquisition options.

Entry Timing and Uncertainty in Transition Economies: Location and Firm Contingencies Revisited

Enrico Pennings (Erasmus U. Rotterdam, NL)

Bas Karreman (Erasmus U. Rotterdam, NL)

Thijs Nacken (Erasmus U. Rotterdam, NL)

In this paper we examine the entry strategies that multinational enterprises (MNEs) pursue when investing in transition economies. Using real option theory combined with notions from institutional- and resource-based theory, we investigate how uncertainty is related to entry timing strategies and how this relation is moderated by host country- and firm level characteristics. Estimating hazard models on entry timing data of 39 multinational banks (MNBs) across 17 different transition economies from 1991 to 2007, we find that uncertainty encourages a wait-and-see strategy and decreases the likelihood of market entry. Furthermore, we find that the relation between uncertainty and market entry strongly depends on institutional features, competitive conditions, MNE size and regional investment experience.

Optimal Timing for Wind Farm Maintenance: An Application and Empirical Evidence

Jonas Pelajo (PUC-Rio, BR)

Luiz Brandão (PUC-Rio, BR)

Leonardo Gomes (PUC-Rio, BR)

Marcelo Klotzle (PUC-Rio, BR)

Wind farms must periodically take their turbines offline in order to perform scheduled maintenance repairs. This interruption impacts the energy generation of the wind farm, so ideally, maintenance should be scheduled for periods with the lowest wind speeds. (which for the Brazilian NE region, is between March and May.) In addition, in order to fulfill contractual obligations, any shortfall in energy production must still be covered by purchasing energy in the spot market, which is volatile. Thus, determining the optimal time to begin maintenance work in a wind farm is a function of both the expected wind speeds and electricity spot prices. In this paper we develop a model to determine the optimal maintenance scheduling in a wind farm based of forecasted wind speeds and energy prices. We analyze a window of 15 weeks in the most promising months of the year, and perform weekly updates of the wind and price forecasts. Wind speeds are forecasted an (ARMAX) model, where monthly dummies were used as exogenous variables to capture the seasonality of wind speeds. Spot prices are simulated under the Newave dual stochastic programing model for a 15 week period beginning in March. The optimal stopping decision is modeled as an American type real option in a modified ABM binomial lattice. We use actual data from a wind farm in the Brazilian NE, and will compare our results with the current practice and also with maintenance scheduling with perfect information, in order to determine the efficiency of the model

3:15 - 3:45 Afternoon Coffee Break

3:45 - 4:30 Keynote Address by Carliss Y. Baldwin (Harvard U.)

4:30 - 5:20 Panel Discussion: Innovation & Real Options

Dean Paxson (U. of Manchester, UK) and
Sarah Von Helfenstein (Value Analytics & Design, USA)

Panelists include:

Carliss Baldwin (Harvard U.)
Luiz Brandão (PUC-Rio, Brazil)
Gill Eapen (Stout, USA)
Kuno Huisman (ASML & Tilburg U, Netherlands)
John Kensinger (U. N. Texas)
Arkadiy Sakhartov (Wharton School, U. of Pennsylvania)

6:00 - 7:30 Networking Reception
Sponsored by ROG and Suffolk University

Day 2 – Friday June 30, 2017

9:00 - 10:15 TRACK I

VC, M&A and Market Entry Strategies

Chairperson: Kuno Huisman (Tilburg U., Netherlands)

M&A Strategies: Small Steps or a Big Leap?

Elmar Lukas ( Otto-von-Guericke-U., Magdeburg, DE)

Paulo Pereira (U. of Porto, PT)

Artur Rodrigues (U. of Minho, PT)

In this paper we study the entrance in a market by means of acquisition when two mutual exclusive strategies are available for the acquirer. One is to choose the big leap strategy, moving directly to acquire the large incumbent, and the other one is to follow a small steps strategy, where the firm first acquires a small company keeping the flexibility to acquire the large player later on. The model we develop helps to define which strategy is preferable for a firm in a given market context, supporting this way the management decision. The model also helps to understand what are the market (or firm specific) condition that favor one strategy against the other. Analytical sensitivity analyses and a numerical example is presented.

VC Portfolio Selection under Different Model Risks

Jani Kinnunen (Åbo Akademi U., FI)

Irina Georgescu (Academy of Economic Studies, RO)

This paper views a venture capitalist's (VC's) portfolio selection problem under three types of uncertainties corresponding to probabilistic, possibilistic, and credibilistic risks. A VC faces such a complex situation, when several potential target companies are under analysis and some are handled in probabilistic terms while others call for a possibilistic or a credibilistic treatment. A possibilistic instead of probabilistic treatment is suitable for cases, where uncertainty is very high. This can be due to lack of available statistical information, because investment targets are often privately owned small companies with limited public information, possibly totally without past sales, without market values, there don't exist comparable firms to allow comparables-based valuations, and their value largely depends on intangibles and their strategic future actions. Credibilistic approach also has similar benefits over a probabilistic approach and certain computation benefits over a possibilistic approach. This paper unifies probabilistic, possibilistic ,and credibilistic portfolio selection models resulting in the optimal solution of the 3-component portfolio problem faced by a VC. The paper discusses the added value and the usefulness of the the approach in VC framework and presents simulation analysis and a calculation example to demonstrate the practicality of the approach.

Investment in a Market with Network Effects for Consumers

Nick Huberts (Tilburg U./De Montfort U., GB)

Jacco Thijssen (U. of York, GB)

In this project we look at the investment behavior of firms in a market where consumers are exposed to network effects. In this model, the profitability of each product depends on the number of consumers. The investment timing is then related to the number of consumers. We show that, under various specifications of consumer incentives, that the resulting process of consumers is mean reverting. Despite standard real options models, this leads to a concave option value. Moreover, this model shows that more uncertainty does not necessarily lead to delaying the investment moment. Finally, for increasing populations we show that the value of waiting disappears.

9:00 - 10:15 TRACK II

Natural Resources

Chairperson: Stein-Erik Fleten (NTNU, Norway)

A Stochastic Supply/Demand Two-factor Model for Storable Commodity Prices

Ali Bashiri (U. of Toronto, CA)

Yuri Lawryshyn (U. of Toronto, CA)

In this work, we propose a two factor stochastic model. The first factor is the commodity’s spot price and the second factor is the "normalized excess supply" for the commodity. This model is unique in that it proposes a mean reverting factor related to supply, demand, and inventory levels and measures the impact of changes in these variables on the commodity prices. Moreover, it is calibrated not only on the commodity prices, but also on the observable supply, demand, and inventory levels. This model is then applied to various commodities ranging from oil to base metals.

Switching from Oil to Gas Production in a Depleting Field: Decisions in a Field's Tail Production Phase

Kristian Støre (Nord U., NO)

Stein-Erik Fleten (Norwegian U. of Science and Technology, NO)

Verena Hagspiel (Norwegian U. of Science and Technology, NO)

Claudia Nunes (U. of Lisbon, PT)

We derive an optimal decision rule with regards to making an irreversible switch from oil to gas production. The approach can be used by petroleum field operators to maximize the value creation from a petroleum field with diminishing oil production and remaining gas reserves. Assuming that both the oil and gas prices follow a geometric Brownian motion we derive an analytical solution for the exercise threshold and demonstrate with numerical examples the threshold for a generic petroleum field. The analytical solution and the general results may also be relevant for other real options cases with similar features.

Evaluation and Optimal Cutting of Forestry Investment

Rebeca Ramos de Oliveira Figueiredo (PUC-Rio, BR)

Frances Fischberg Blank (PUC-Rio, BR)

Marco Antonio Guimarães Dias (PUC-Rio, BR)

The modern financial literature recommends the real options approach to incorporate uncertainty and managerial flexibilities in forestry investment projects. This work aims to develop a valuation model for forestry projects in which the growth of tree inventory follows a logistic equation based on the estimated real growth of a forest. This paper aims to quantify the economic benefits of an optimal production policy driven by tree cutting in a eucalyptus forest. The model includes three independent state variables (inventory, time, and price, the last one modelled as a geometric Brownian motion) and two dependent variables: cutting rate and the value of the investment option. The results, obtained through the explicit finite difference method, are compared to other alternatives of inventory evolution and cutting rate decisions. The results show that adopting an optimal cutting policy based on real options theory has a great advantage. Moreover, the forest option value is higher when inventory growth is modelled by the deterministic logistic equation compared to the stochastic logistic equation.

10:15 - 10:45 Morning Coffee Break

10:45 - 12:00 TRACK I

Hedging, Diversification & Partnering Strategies

Chairperson: Arkadiy Sakhartov (Wharton School, U. of Pennsylvania)

Feeder Cattle Livestock Options: Where's the Beef?

Glaucia Fernandes (PUC-Rio, BR)

Luiz Eduardo Teixeira Brandão (PUC-Rio, BR)

Carlos de Lamare Bastian Pinto (IBMEC, BR)

Feeder cattle is one of the most important sectors of the Brazilian livestock industry. Nonetheless, this sector is subject to many uncertainties, which requires firms to use risk management tools such as options. In this paper we discuss the real and financial options available to a feeder cattle producer, and analyse the option to switch livestock sales between the spot and the futures market. We also analyze put options contracts traded in the futures market of feeder cattle and compare prices derived from different option pricing models. We use actual put options prices on livestock futures from the BM&FBovespa, which is the main stock exchange in Brazil, and analyze if these are priced according to what classic models suggest. For the pricing of livestock options, we give particular attention to the results considering different types of volatility, different maturity months, degrees of moneyness and different maturity dates. Tests of mean differences are conducted to examine if there are statistically significant differences between the Longstaff and Schwartz, Barone-Adesi and Whaley, Bjerksund and Stensland and Cox, Ross and Rubinstein models. The results indicate that the switch is a valuable option, that prices derived from the theoretical models are close to the realized prices, and that the best pricing is obtained with the use of the implied volatility.

Economies of Scope, Resource Relatedness and the Dynamics of Corporate Diversification

Arkadiy Sakhartov (The Wharton School, U. of Pennsylvania, US)

The dominant view has been that businesses that are more related to each other are more often combined within diversified firms. This study uses a dynamic model to demonstrate that, with inter-temporal economies of scope, diversified firms are more likely to combine moderately related businesses than the most related businesses. That effect occurs because strong relatedness reduces redeployment costs and makes firms redeploy all resources to better performing businesses. The strength of that effect depends on inducements for redeployment measured as the current return advantage of one business over another business, volatilities of business returns, and correlation of those returns. This study develops hypotheses for those relationships and suggests empirical operationalizations, encouraging empiricists to retest the implications of relatedness for the dynamics of corporate diversification.

Acquiring vs. Partnering with a Small Technology Firm under Competition

Linda Salahaldin (Telecom Ecole de Management, FR)

We develop a real options framework for the acquisition of small firms by larger ones interested in their technology. We show that, in the presence of uncertainties related to the efficiency of the technology of the target firm and the pressure of the competition, the large firm has incentives to partner with the small one, allowing for a hedging against the competition. This modeling leads to the assessment of the value of this partnership as the difference between the value of the proprietary option and that of the option under competition.

10:45 - 12:00 TRACK II

Upgrade & Switching

Chairperson: Peter Kort (Tilburg U., Netherlands)

Optimal Upgrade of a Depleted Resource to a More Appropriate Technology: An Application to Offshore Oil Rigs

Roger Adkins (U. of Bradford, GB)

Dean Paxson (U. of Manchester, GB)

A physical asset upgrade, in contrast to a like-for-like replacement, describes a switch to a technological alternative more appropriate for the depleted state of the underlying resource. Off-shore oil rigs are an illustration, since their technological scale designed for very large output flows becomes inappropriate as their operational efficiency falters later in life as the output flow dwindles and a more appropriate extraction technology becomes economic. A real option representation of this phenomenon is formulated on a stochastic oil price and deteriorating output volume. The resulting two-factor model yields analytical results that switching is increasingly deferred as the cost structure for the upgrade becomes adverse and the volatility decreases, but is advanced by increasing depletion rate and convenience yield. Under certain conditions, the oil rig is divested and not upgraded, an occurrence common for the North-Sea fields.

Product Upgrade Timing in Durable Goods with Significant Malfunction Risk

Maria Lavrutich (NTNU, NO)

Verena Hagspiel (NTNU, NO)

Simen Ingebrigtsen (NTNU, NO)

Steinar Bækkedal (NTNU, NO)

This paper studies investment behavior of firms deciding when to introduce an upgrade in a durable goods monopoly. The firm chooses both the investment timing and the price of the upgrade while facing the risk of the upgrade experiencing a serious malfunction and requiring a complete recall. More specifically, the paper aims to show what incentives a firm may have to introduce an upgrade early and accept the higher malfunction risk. The firm can reduce this risk by performing product tests of uncertain duration. We show that the willingness to introduce an upgrade early with significant malfunction risk is larger when (i) the demand for the existing version has weakened, (ii) the quality and stock of potential customers for the upgrade is high or (iii) the testing process is slow.

Enhancing Flexibility and Innovativeness: Options to Choose the Best Among Several Alternatives from the Physical or Information Realm

John Kensinger (U. of North Texas, US)

James Conover (U. of North Texas, US)

Andrew Chen (Southern Methodist U., US)

Option models have provided insight into the value of flexibility to switch from one state to another (such as switching a mine or refinery from operating to closed status). More complex flexible processes offer multiple possibilities for switching states. A fabrication facility, for example, may offer options to shift from the current status to any of several alternatives (reflecting reconfiguration of basic facilities to accommodate different operating processes with different outputs). New algorithms enable practical application of complex option pricing models to flexible facilities, improving analysts’ ability to draw sound conclusions about the effects of flexibility and innovativeness on share value. Careful attention to estimating the matrix of correlations among the values of potential alternative states allows explicit integration of financial analysis and strategic analysis—especially the influence of substitutes and the anticipated reactions of competitors, suppliers, and potential new entrants.

12:00 - 2:00 Luncheon

2:00 - 3:15 TRACK I

Innovation, Patenting & Investment Timing

Chairperson: Artur Rodrigues (U. of Minho, Portugal)

Innovation Effort, Spillovers and Patent Licensing Strategy

Benoit Chevalier-Roignant (King's College London, GB)

Tailan Chi (U. of Kansas, US)

Lenos Trigeorgis (King's College London, U. of Cyprus & MIT, US)

The Innovator’s Dilemma Revisited: Investment Timing, Capacity Choice and Product Life Cycle

Elmar Lukas (Otto-von-Guericke-U. Magdeburg, DE)

Stefan Kupfer (Otto-von-Guericke-U. Magdeburg, DE)

Innovative industries like the semiconductor or flat-panel industry have been a driving momentum of global growth for decades. However, global competition, constant decline of output prices, rocketing costs, and shorter life-cycles put great stress on making the right investment policy. By means of a Markov-regime switching model we model the simultaneous choice of optimal investment timing and capacity under uncertainty in continuous time. Our results indicate that, the threat of disruptive technological change lead to install less capacity later. If uncertainty levels in each demand regime are different, we find that both optimal capacity and timing threshold become ambiguous. For low degrees of uncertainty in the decline regime, an increase of uncertainty leads to an increase of the investment threshold and a decrease of the optimal capacity in the growth regime.

Tax and Subsidy Incentives and their Effect on Investment Timing and Scale

Alcino Azevedo (Aston Business School, Aston U., GB)

Paulo J. Pereira (U. of Porto, PT)

Artur Rodrigues (U. of Minho, PT)

We develop a real options model which examines the effect of subsidies and tax incentive policies considering depreciation. We show that a lower tax rate, or higher depreciation rate or subsidy always accelerate investments. On the other hand, the scale of the investment depends on the choice of the demand function and the type of subsidy. Specifically, we find that a higher tax rate or lower depreciation rate leads to investments of larger scale for an additive inverse linear demand function, but have no effect on the size of the investment for both multiplicative linear and iso-elastic demand functions. Regarding the effect of the subsidy on investment behavior, we find that a fixed subsidy always induces smaller scale investments, whereas variable subsidies induce investments of larger capacity when a multiplicative or iso-elastic demand functions hold and investments of smaller capacity when an additive demand function is in place.

2:00 - 3:15 TRACK II

International Investing: Tax & Location Incentives

Chairperson: Yuri Lawryshyn (U. of Toronto, Canada)

Foreign Direct Investment with Tax Benefits under Uncertainty

Alcino Azevedo (Aston U., GB)

Paulo Pereira (FEP, U. of Porto, PT)

Artur Rodrigues (U. of Minho, PT)

We develop a real options model which evaluates the optimal time to invest in an FDI project when there is a period over which the firm benefits from a more favourable tax rate (tax holiday period), and the market profits and the tax policy are both uncertain. We find that if the tax rates during and after the tax holiday period are certain, firms invest earlier the longer is the tax holiday period and the lower are the tax rates. Yet, when there is uncertainty about the tax rate over the tax holiday period, nonlinear and complex investment criteria hold.

Optimal Dual Sourcing in Offshore Production

Matt Davison (U. of Western Ontario, CA)

Yuri Lawryshyn (U. of Toronto, CA)

Volodymyr Miklyukh (U. of Toronto, CA)

Profit maximization in the retail and manufacturing industry is currently focused on offshore production to utilize their low production costs. However, with an unknown consumer demand, it is difficult to determine an optimal order quantity which maximizes profit. We consider a single-period dual-sourcing problem for perishable or seasonal goods under a general demand distribution with unknown customer demand. Using real options theories, we provide a pseudo-analytical solution which can be easily solved to determine an optimal offshore and local order quantities based on the manufacturers’ lead times. Future work would consider multiple demand and sourcing periods from the local manufacturer to determine a more realistic scenario. This more complicated approach, however, will no longer be psuedo-analytical and will require numerical methods to solve. Furthermore, we can consider the demand to be an observable process correlated to a traded, which can be hedged to reduce profit uncertainty.

Multicountry Patenting under Uncertainty

Benoit Chevalier-Roignant (King's College London, GB)

Janja Annabel Tardios (King's College London, GB)

Recent studies have showed that multinational firms increasingly pursue multicountry patenting strategies. This article provides novel insights and empirical evidence on the effect of uncertainty on the incentive to adopt such strategies. While the antecedents of multicountry patenting in multinationals have been addressed (e.g., manufacturing integration), as well as specific benefits pointed out (e.g., heterogeneity of knowledge), we still lack a full understanding of the drivers of firm decisions to pursue these strategies. In fact, other studies point out the continued preference for in-house, single country patenting. Using real options logic, we develop and test a set of hypotheses examining the impact of multicountry vs. single country patents on the value of a firm’s portfolio of market entry options based on transfer costs in pharmaceutical multinationals. Consistent with our model, we show that market uncertainty has distinct effects on incentive to follow certain patenting strategies.

3:15 - 3:45 Afternoon Coffee Break

3:45 - 5:00 TRACK I

Innovation & Games

Chairperson: Richard Ruble (EMLYON Business School, France)

Disruptive Innovation in a Declining Market

Verena Hagspiel (NTNU, NO)

Kuno Huisman (Tilburg U., NL)

Peter Kort (Tilburg U., NL)

Claudia Nunes (Instituto Superior Tecnico Lisbon, PT)

Rita Pimentel (Instituto Superior Tecnico Lisbon, PT)

The paper considers the problem of a firm operating in a declining market. The firm has an option to innovate and has to derive the right time to do so, if at all. We find that it can be optimal for the firm to innovate because of two reasons. The first reason is that a new technology is available with which the firm can achieve higher profits. The second reason is that, due to demand saturation, profits of the established product have become so low that the firm will adopt a new technology even if the newest available innovation has not improved for some time. We obtain that the firm essentially has two candidate policies for optimality: innovate early and keep on producing both the established and the new product, or innovate late and replace the established product by the new one.

Option Value and the Innovation Incentives of Small and Large Firms

Richard Ruble (EMLYON Business School, FR)

The interaction of option value and the innovation incentives of monopolistic and competitive firms is studied. Arrow's (1962) replacement effect holds very generally in a stochastic dynamic setting, favoring innovation by competitive firms. But imperfections in patent protection or an arbitrarily small likelihood of successful imitation suffice for the monopoly innovation option to be more valuable when a novel idea is "pioneering" enough so that the optimal moment to develop the innovation is currently remote. If the magnitude of innovation is endogenized so that it is the firm that determines whether or not an innovation will be drastic, then sufficient uncertainty leads competitive innovators to favor drastic innovations whereas monopolies invest later and in larger projects.

Capacity Optimization for Innovating Firms: When to Replace the Existing Production Process?

Verena Hagspiel (NTNU, NO)

Kuno Huisman (Tilburg U., NL)

Peter Kort (Tilburg U., NL)

Cláudia Nunes (Instituto Superior Técnico, PT)

Rita Pimentel (Instituto Superior Tecnico Lisbon, PT)

In case of a product innovation the firms start producing a new product. While doing so, such a firm should decide what to do with their existing production process after the firm has innovated. Essentially it can choose between replacing the established production process by the new one, or keep on producing the established product so that it produces two products at the same time. Aim of this paper is to design a theoretical framework to analyze this problem. Due to technological progress the quality of the newest available technology, and thus the quality of the innovative product that can be produced by this technology, increases over time. The implication is that a later innovation enables the firm to produce a better innovative product. So, typically the firm faces the tradeoff between innovating fast that enlarges its payoff soon but only by a small amount, or innovating later that leads to a larger payoff increase, the drawback being that the firm is stuck with producing the established product for a longer time.

3:45 – 5:00 TRACK II

Public Policy Issues

Chairperson: Elizabeth Whalley (U. of Warwick, UK)

Bouncing Back: Assessing the Resilience of Infrastructure Projects and the Use of Average Outage Factors

Afzal Siddiqui (U. College London, GB)

Ryuta Takashima (Tokyo U. of Science, JP)

Motivated by the need to bolster the resilience of infrastructure, such as bridges, nuclear power plants, and ports, in face of extreme weather events, we consider two types of projects: "riskier" and "safer." Each type of project, once constructed, earns identical instantaneous cash flows and is subject to the same risk of outage, which causes its cash flows to diminish. The only difference between the two projects is that the repair rate of the "safer" project is greater than that of the "riskier" one. Naturally, the "safer" project is more valuable to an investor due to its greater resilience. However, how much extra would an investor be willing to pay for this resilience? Under which circumstances would it be reasonable to replace the outage and repair rates with average outage factors? Using a real options approach, we show that even though the proportions of up- and down-times remain fixed, changes in the transition rates affect the willingness to pay for resilience. This implies that use of average outage factors will incorrectly inflate the resilience premium. In fact, only in the limit when transitions occur at infinitely high rates does the use of average outage factors accurately reflect the investor's willingness to pay for resilience. Somewhat paradoxically, very frequent transitions reflect a situation in which average outage factors may be used.

Adaptation to Catastrophic Risk under Climate Change Uncertainty: A Bayesian Real Options Approach

Chi Truong (Macquarie U., AU)

Stefan Trueck (Macquarie U., AU)

Tak Kuen Siu (Macquarie U., AU)

We present a novel framework for the valuation of investments to mitigate catastrophic risk of climate impacted hazards. Our model incorporates the impact of uncertainty and continuous Bayesian information updating on investment decisions. We show that the model is relevant even when the time required to resolve uncertainty is indefinite. The model is applied to bushfire risk management in a local area. Our findings suggest that investment based on the net present value (NPV) rule that ignores the value of the investment option results in significant losses. Sensitivity analysis results suggest that the loss is large when the investment cost is high, when the uncertainty resolution is slow, or when the probability belief in climate change is low.

Optimal Time to Adopt Control Measures Given Uncertainty in Disease Spread

Ciara Dangerfield (U. of Cambridge, GB)

Elizabeth Whalley (U. of Warwick, GB)

Nicholas Hanley (U. of St Andrews, GB)

John Healey (U. of Bangor, GB)

Christopher Gilligan (U. of Cambridge, UK)

The real options approach provides a powerful tool for determining the optimal time at which to adopt disease control measures given that there is uncertainty about the future spread of an invading pest or pathogen. Previous studies have considered the timing of control from the point of view of a central planner. However, decisions regarding the deployment of control measures are typically taken by individual forest managers, who may have widely differing objectives. In this article we investigate how management objectives impact the optimal timing of control measures given uncertainty in disease spread. Our results show that differences in management objectives can lead managers to act at different times, and potentially never adopt disease control. In particular, these differences in the timing of disease control for diverse types of managers become more significant if the disease impacts the range of benefits from the forest to varying extents. This creates tensions at the landscape scale if there are managers with divergent objectives due to the transferable externality (the disease). Targeted subsidies which lower the ongoing costs of control can reduce differences in control strategies between managers with divergent objectives. Our results have important implications for national decision making bodies and suggest that incentives may need to be targeted at specific groups to ensure a coherent response to disease control.

Day 3 - Saturday July 1, 2017

9:00 – 10:15 TRACK I

Financing & Capital Structure

Chairperson: Gordon Sick (U. of Calgary, Canada)

The Role of Equity Financing in Debt Renegotiation

Florina Silaghi (Universitat Autonoma de Barcelona, ES)

Debt renegotiation is often modeled as pure debt for equity or debt for debt swaps. In this paper we analyze the use of equity financing in addition to debt financing in debt repurchases. Firms with larger volatility, lower cash flow growth rates, or higher recovery rates are more likely to use equity financing in debt renegotiation. Flotation and renegotiation costs, the bargaining power of the creditors, and macroeconomic variables also influence this choice. When equity issuance is a possible source of financing in renegotiation, firms optimally choose larger debt reductions as compared to pure debt for debt swaps. The use of equity financing increases welfare. We provide closed-form solutions for the optimal use of funding and we derive novel testable empirical implications regarding the use of equity financing in debt repurchases.

Start-up Financing with Convertible Notes, Second-Round Equity and the Trustworthiness of the Entrepreneur’s Fund Raising Ability Under Asymmetric Information

Yasuharu Imai (U. of Caen Normandy, FR)

Convertible notes are commonly used in start-ups financing. Focusing on the relationship between two different types of investors, a second-round equity investor and a first-round convertible note holder, this paper simulates how the value of option to convert of the convertible note holder can be affected by the trustworthiness of the second-round equity investor to the entrepreneur’s ability to procure funds and to increase firm’s value in each financing round. The result of a real case simulation with a real options approach suggests, firstly, that the improvement of the investor’s trustworthiness to the entrepreneur’s ability has a great impact on the amount that the entrepreneur should offer and procure when the second-round equity investors are quite doubtful about the entrepreneur’s ability and the convertible notes are chosen more preferably than equity. Secondly, the preference of convertible notes over equity becomes less strong when the investor’s trustworthiness to the entrepreneur’s ability is improved, especially in the lower range of trustworthiness.

Illiquidity and Indebtedness: Optimal Capital Structure under Realistic Default Triggers

Tim Kutzker (U. of Cologne, DE)

Maximilian Schreiter (HHL Leipzig, DE)

Alexander Lahmann (HHL Leipzig Graduate School of Management, DE)

Existing dynamic capital structure models are based on a single barrier determining bankruptcy, e.g. overindebtedness or illiquidity. However, it is observable that these approaches do not perform well empirically and omit a variety of constraints faced by equity and debt holders. This article incorporates these constraints examining corporate debt value and optimal capital structure in a double barrier world with knock-in and knock-out barrier options. The results elucidate why considering only one barrier distorts the estimates of risks for default and bankruptcy. In fact, the single barriers illiquidity and overindebtedness take the role of boundary conditions. Incorporating both conditions in this novel double barrier approach allows for capital structure estimations that are in better accordance with empirical findings. Beyond capital structure theory, other fields of economics and even medical science or the humanities are in context of problems that can be solved with such a double barrier approach.

9:00 – 10:15 TRACK II

Theoretical Issues

Chairperson: Motoh Tsujimura (Doshisha U., Japan)

American Perpetual Options with Random Start

Fredrik Armerin (KTH, SE)

We consider the valuation of American perpetual options with the property that they are only possible to exercise after a random time has occured. One situation where this feature is present is when we want to value the real option of when to build on vacant land and we are waiting for a permit. The random time in this case is the time at which the permit is given. This and the value of a version of an abandonment option are given as two applications of this modelling framework.

Financing Uncertain Growth Options

Nikolaos Georgiopoulos (Bermuda Monetary Authority, BM)

In this paper we study the financing of high uncertainty projects. High uncertainty is defined as the lack of knowledge of whether growth options exist. In this paper we will describe this uncertainty by a probability distribution which describes the arrival of a growth option at a deterministic time. Once the option arrives an additional uncertainty exists since it is not certain that it is profitable to exercise it. We value the corporate securities with contingent claims valuation both for a whole equity financed firm and a debt-equity financed firm. Unlike traditional capital structure models, we find non-convex value functions for the firm vis-a-vis the debt coupon under specific parametrizations. High and low leverage can yield similar firm value maximizing policies.

Optimal Investment Strategy under (Levy) Ambiguity

Junichi Imai (Keio U., JP)

Motoh Tsujimura (Doshisha U., JP)

This paper examines an optimal investment problem of Abel and Eberly (1997) and Imai and Tsujimura (2016) under higher degree of ambiguity. The ambiguity indicates a manager's disconfidence with respect to the underlying model. It can be formulated as allowing one to change the reference probability measure into a different equivalent probability measure. The difference between the reference measure and another equivalent measure indicates the manager's misspecification of the underlying model. In the formulation, on the one hand, the firm's manager chooses the investment level to maximize the firm's value. On the other hand, Nature chooses the equivalent probability measure so that the firm's value is minimized. Consequently, the optimal investment problem developed in this paper can be formulated as a maxmin expected utility problem. It is crucial to notice that an adoption of a Le'vy process enables us express higher degree of ambiguity, that is, unlike the diffusion process, when the underlying asset follows an exponential Le'vy process, a change of measure can affect not only its drift term of the diffusion but also its variance, skewness and kurtosis via changing the jump structure of the original Le'vy process. Consequently, in this paper, we can express higher level of ambiguity, i.e, our model can describe potential misspecification with respect to its higher moments of the distribution.

10:15 - 10:45 Morning Coffee Break

10:45 – 12:00 TRACK I

Financing Infrastructure & Special Payoff Structures

Chairperson: Dean Paxson (U. Manchester, UK)

Guarantees in Toll Road Projects: An Application in Colombia

Carlos Andrés Zapata (U. Externado of Colombia, CO)

Carlos Armando Mejía (U. Externado of Colombia, CO)

This paper develops a proposal for the estimation of a Minimum Revenue Guarantee for a toll road project with private financing in Colombia, supported by Real Options Analysis (ROA). Specifically, we overcome the problem of guarantees valuation in a context where the government assumes the risk of vehicular traffic in order to guarantee a minimum level of revenue and profitability to the investors. Based on this, we can estimate the value of the resources committed by modeling the vehicular traffic dynamic over time with an extended Ornstein-Uhlenbeck process. Finally, an alternative solution to finance projects that doesn’t attract private investors is found.

Risk-shared Financing of Infrastructure Investment (Concessions) with Revenue Floors and Ceilings

Dean Paxson (Manchester U., GB)

Roger Adkins (Bradford U., GB)

A real option model is formulated for infrastructure investments with collars, or revenue floors or ceilings. The risk sharing between the principal (government granting the concession) and the agent (concessionaire) is quite different for these alternative arrangements.

Endogenizing Investment Cost under Uncertainty: Irreversibility Revisited

Yishay Maoz (Open U. of Israel, IL)

Doron Lavee (Tel Hai Academic College, IL)

The typical model of investment under uncertainty where firms pay an irreversible cost in order to produce is revisited, this time with a novel focus on the recipient of this payment. This recipient is modeled as a firm that sells a resource (or a right) necessary for the production of the final good. We find the optimal price that the resource owner sets for its resource, and study how it depends on the characteristics of the market for the final good. The analysis reveals that one of the main results of the literature on investment under uncertainty – that firms delay their investment even when its NPV is positive – may not survive the endogenization of the investment cost, or at least loose much of its plausibility.

10:45 – 12:00 TRACK II

Overconfidence, Outsourcing & Option Portfolios (Best Student Papers Session)

Chairperson: Afzal Siddiqui (University College London, UK)

Do Overconfident CEOs Ignore Minority Stake Acquisitions (Toehold Strategies)?

Han Smit (Erasmus U. Rotterdam, NL)

Nishad Matawlie (Erasmus U. Rotterdam, NL)

In a toehold strategy, an acquirer buys a minority stake with the intention to gain control of a target later. Yet despite the claimed advantages toehold strategies offer, acquirers only rarely buy toeholds. This study presents a behavioural dynamic model and empirical evidence, showing that overconfidence of CEOs causes them to forgo the more prudent toehold strategy to make immediate controlling acquisitions instead. We find a negative relation between the likelihood of acquiring a minority stake and CEO overconfidence, revealed through measures based on the timing of their option portfolio and on external perception. Overconfident CEOs also purchase on average larger fractions of their targets. Furthermore, the acquirer returns on toehold announcements tend to be higher than majority stake acquisitions. We conclude that CEO overconfidence causes acquirers to forgo minority stake acquisitions, despite the advantages of minority stakes versus controlling acquisitions.

Outsourcing and External Funding: Effect on Innovation Investment Efficiency and Timing

Dimitrios Zormpas (U. of Padova, IT)

In this paper we consider a potential investor who contemplates entering an uncertain new market under two conditions: i) a prerequisite for the project to take place is the purchase of a discrete input from an upstream firm with market power and ii) the completion of the investment is conditional on the participation of an investment partner who is willing to bear some of the investment cost receiving compensation in return. Using the real option approach, we find that the involvement of any of the two alien agents causes the postponement of the completion of the investment and we discuss how these timing discrepancies are reflected on the value of the option to invest in the project. We next analyze the synchronous effect of outsourcing and external funding both in a non-cooperative and in a cooperative (Nash bargaining solution) game-theoretic setting and we show how the endogeneity of the sunk investment cost affects the timing and the value of the option to invest in projects characterized by uncertainty and irreversibility.

Valuing Portfolios of Interdependent Options under Exogenous and Endogenous Uncertainties

Sebastian Maier (Imperial College London, GB)

Although the value of portfolios of real options is often affected by both exogenous and endogenous uncertainties, most existing valuation approaches consider only the former and neglect the latter; the few that deal with both types of uncertainty are impractical. In this paper we extend our existing approach for modelling and approximating the value of portfolios of interdependent real options to include endogenous, decision- and state-dependent uncertainties using stochastic processes. In particular, we study a portfolio of options: to defer investment; stage investment; temporarily halt expansion; temporarily mothball operation; and abandon the project under conditions of four underlying uncertainties. Two of these, decision-dependent cost to completion and state-dependent salvage value, are endogenous, the other two, annual revenues and their growth rate, are exogenous. The directly modelled dynamics of all four uncertainties and the linear integer constraints modelling the real options' interdependencies are integrated in a multi-stage stochastic integer programme. Using a simulation and regression approach to approximate the value of this optimisation problem, we present an efficient valuation algorithm. The applicability of the approach to complex investment projects is illustrated by valuing an urban infrastructure investment in London. In this example we show how the optimal value of the portfolio and its single, well-defined options is affected by the initial level of the annual revenues.


Moderator: Gordon Sick (U. of Calgary, Canada)

Panelists Include:

Stein-Erik Fleten (NTNU, Norway)
Peter Kort (Tilberg U., Netherlands)
Yuri Lawryshyn (U. of Toronto, Canada)
Artur Rodrigues (U. of Minho, Portugal)
Afzal Siddiqui (University College London, UK)
Elizabeth Whalley (U. of Warwick, UK)




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