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Annual International Conference on Real Options: Theory Meets Practice

Abstracts and Links to Papers

6th Annual Real Options Conference

Paphos, Cyprus

July 2002

DAY 1 - Thursday July 4

7:15 - 8:00 Registration and Continental Breakfast


8:00 - 8:40 Chairperson's Welcome & Address


Real Options and Investment Under Uncertainty

Lenos Trigeorgis, U. Cyprus and President, Real Options Group


9:00 -10:00 Ventures I: Introductory

Chair: Anthony Saunders, New York University


Real Options Implications On Venture Capitalist's Investment Decision-Making Behavior

Lip Soon (Andrew) Wong, Multimedia University


An overriding issue on the agenda of todayÓs venture capitalists concerns their investment decision-making. Their fundamental concern is compounded by methodological difficulties: a) traditional net present value (discounted cash flow) evaluations are inadequate for many risky projects, and b) the available methods for valuing these projects are limited and often impractical. Good investment decision-making has often been described as following: - an orderly and logical process from framing investment decision-making problem, searching and evaluating of alternatives, and choosing the best option to investment. Compressed decision time and increase complexity are disturbing the orderly flow of information and proper flow of investment decision-making authority structure. Managers are turning to new approaches, emphasizing on options thinking, managerial flexibility and resource flexibility. This paper describes the implications of the presence of real options in investment decision-making situations and how the presence of real options changes the managers' investment decision-making behavior. Real options reasoning is a logical for funding projects that maximizes learning and access to upside opportunities while containing costs and downside risk. Although it has considerable advantages over conventional approaches, the methodology to make some intelligent conjectures remains scare. This paper describes and illustrates a methodology to understand the behavior change of investment decision-making with and without the presence of real options. The research exercise demonstrates the behavioral changes implications with and without the presence of real options. This paper seeks to develop theory or compare patterns by looking at four main questions that will be answered through a series of exercises. The 4 questions are stated below: - 1. Given the choice to choose several investment decision-making options, will the investment practitioners change their investment decision-making behavior? 2. Given the choice to choose several investment decision-making options, how will the investment practitioners change their investment decision-making behavior? 3. How does the behavioral change evolved through proper learning of real options flexibility, such as managerial flexibility and flexible resource allocations? 4. How sustainable and adaptable will the behavioral change in investment decision-making of the investment practitioners through the time? This paper focuses on six aspects of the process that venture capitalist use to select and structure investments: investment strategy, deal flow generation, screening, due diligence, valuation, and investment structure. Decision-making regarding these processes of selecting and structuring investments also followed the standard model of decision-making: Investment practitioners make assessment on the current issues or situations, alternative decisions are listed and evaluated as to the managers objectives, risk and reward factors and so on often using traditional valuation methodology; a decision was made and implemented. In this paper, I will describe a series of approach to evaluating investment decision-making through experimental economics. For example, controlled experiment will be use to ask respondents to score a series of statements to understand and investigate their investment decision-making behavioral changes. Given the relentless development of investment field, complexity in investment decision-making can only be expected to increase. This promises lead to more intense and complex challenges for decision makers, but through the exercise and better understanding of their investment decision-making behavior, investment practitioners will have equip themselves with powerful understanding for addressing these complex and dynamic decisions. In this paper, I will describe a series of approach to evaluating investment decision-making through experimental economics. For example, controlled experiment will be use to ask respondents to score a series of statements to understand and investigate their investment decision-making behavioral changes. Given the relentless development of investment field, complexity in investment decision-making can only be expected to increase. This promises lead to more intense and complex challenges for decision makers, but through the exercise and better understanding of their investment decision-making behavior, investment practitioners will have equip themselves with powerful understanding for addressing these complex and dynamic decisions.


Valuing a Private Equity Venture Investment: The Case of a B2B Marketplace Start-Up

Anett Mehler-Bicher, European Business School, Germany

Martin Ahnefeld, European Business School, Germany


The application of option theory to problems in information technology and especially to e-business has been the subject of some research in the last years. Prior research especially targeted the demonstration of the power of real options through applying fundamental option pricing models, such as the Black-Scholes or the binomial models, on real world cases. As a result, option theory offers high potential for useful insights regarding the evaluation of irreversible investments under uncertainty and requiring flexibility. A great number of e-business investments is initiated by early stage companies œ mostly financed by venture capital or private equity. Due to the sharp declination of stock prices of new economy companies in 2000 venture capitalists have realized that they have paid too high prices for their equity stakes. They have to admit that new economy market was driven by euphoria rather by fundamental values. By such a crash, the applied valuation methods are questioned. Venture capitalists dealing with seed and startup companies on their daily basis need realistic and sensible valuations in order to make profitableinvestment decisions. However, the valuation of those high growth companies is difficult and presents a big challenge. Most of those companies have negative earnings and no or only small revenues. In addition, comparable companies are rare or required information not accessible to the public which makes it very difficult to apply multiple valuation. Regarding the private equity market start-up venture consists of many options due to high flexibility and uncertainty of their future development. Also from an investorÓs perspective an investment in an early stage company may incorporate several options such as future follow-up investments, which will be carried out if the company proceeds successfully. Traditional valuation methods such as DCF are not able to capture and price such options, but with option theory it is possible to assign them a fair value. As a consequence, the aim of this research paper is to apply and test a variation of the real option method on private equity investments. Based on the case study approach a fictive B2B marketplace at the start-up financing round in the end of 2000 is discussed. On behalf of confidentiality agreements signed within the venture capital market it is not possible to access real world cases, which makes it compulsory to use a fictive case. The goal is to precisely define and calculate the individual steps of the real option approach in order to derive an accurate and correct valuation of the B2B marketplace at the given financing round. This research paper makes three important contributions in this context: (1) it systemizes the application of real option models in the scope of private equity, (2) it demonstrates the feasibility of option theory for assessing private equity investments and (3) it shows a tendency concerning cost-benefit ratio if option theory is applied on private equity investments.


10:30 - 12:00 Ventures II: Design and Contracting

Chair: David Robinson, Columbia University


Optimal Staging of Venture Investments

Hongjiang Li, Dalian University of Technology, China


Real options approaches can be employed to value the flexibility in the decision-making courses of phased investments. This paper focuses on the two-stage investment problems of venture firms. Firstly, two real options are recognized by real options thinking. After that, based on the analysis of profit function, stochastic models are proposed to describe the uncertainties those are inherent in markets. Then the value function of decision-making flexibility is derived as well as the vital executable probability of the two real options. Finally numerical techniques are employed to calculate the optimal proportions of a case and the influence of investment proportions upon the flexibility value is also analyzed.


Understanding the Economic Value of Legal Covenants in Investment Contracts

Didier Cossin, HEC, University of Lausanne and IMD

Benoit Leleux, IMD- International Institute for Management Development

Entela Saliasi, HEC, University of Lausanne and FAME


Valuing early-stage high-technology growth-oriented companies is a challenge to current valuation methodologies. This inability to come up with robust point estimates of value should not and does not lead to a breakdown of market liquidity: instead, efforts are redirected towards the design of investment contracts which materially skew the distribution of payoffs in favor of the venture investors. In effect, limitations in valuation abilities are addressed by designing the investment contracts as baskets of real options instead of linear payoff functions. This paper investigates four common features (covenants) of venture capital investment contracts from a real option perspective, using both analytical solutions and numerical analysis to draw inferences for a better understanding of contract features. The impact of the concept for pricing issues, valuation negotiation and for contract design are considered. It is shown for example how ''contingent pre-contracting'' for follow-up rounds is theoretically a better proposition than the "rights of first refusal" commonly found in many contracts.


Financial Contracting in Biotech Strategies Alliances

David Robinson, Columbia University

Toby Stuart, University of Chicago


We conduct a detailed, micro-level analysis of 126 strategic alliance contracts, all of which were written to sponsor early-stage, genomics-based biotechnology research at small R&D companies. All contracts prescribe staged investment decisions to capture the option value associated with the sequential resolution of uncertainty, but the contracts deal with agency problems di
erently. Among pre-IPO companies, many alliances resemble venture capital contracts: they involve convertible preferred equity and sometimes contain anti-dilution provisions, warrants, and board seats. Contracts contain explicit provisions linking equity participation to subsequent IPO activity, and contain clauses designed to insulate both parties from multi-tasking problems. Contrary to the standard assumptions of static contract theory, contracts often specify provisions that are unobservable or diffcult to verify. Equity participation is positively correlated with the ambiguity of the contracting environment.
JEL Classification Codes: G30, G34, G39, M13, O39


1:30 - 3:00 Competition and Strategy

Chair: Helen Weeds, Lexecon Inc.


Strategic Dynamic R&D Investments

Ruslan Lukach, University of Antwerp

P.M. Kort, University of Antwerp and Tilburg University

J. Plasmans, University of Antwerp and Tilburg University


In this paper we present a model, which describes firmsØ strategic R&D investment under technological uncertainty. It assumes two symmetric firms making strategic decisions about undertaking two-stage R&D subject to uncertainty in the outcome of the first exploratory stage. The model concludes that using real options to evaluate the R&D investments allows the firm to undertake larger investment projects when uncertainty is large. Also using the real options creates more complex strategic interactions between the competing agents in a duopoly. If the R&D is profitable for both agents, they will invest symmetrically and compete later in production. But the technological uncertainty together with the strategic interaction between two agents can lead to the outcome when it is profitable for one agent to invest in R&D only when another agent does not. The "leader" gets a largermarket share and is capable of conducting the R&D in amounts, which otherwise are nonprofitable under regular symmetric conditions or if the first-stage exploratory R&D did not succeed. JEL Classification: C72, D21, O31 Keywords: Investment under Uncertainty, Real Options, R&D, Competition


Timing Advantage: Leader/Follower Value Functions if the Market Share Follows a Birth and Death Process

Dean Paxson, Manchester Business School

Helena Pinto, Doctoral Programme-Manchester Business School


For a duopoly environment, we model the leader and follower value functions assuming that the leader's' market share evolves according to an immigration (birth) and death process. We derive explicit solutions for the follower's option to invest, and numerical solutions for the leader's option to invest. Then we calculate the partial derivatives of the leader and follower value functions to market share, birth/death parameters, volatility and market profitability. This model is possibly more realistic than that proposed by some other authors studying the advantages of being first (and also being a follower). We show that over certain ranges of the parameter values, the leader and follower real options to wait to invest, and not to wait to invest, are sometimes surprising and not immediately intuitive.


Real Options and Competition: The Impact of Depreciation and Reinvestment

Alfons Balmann, Fachhochschule Neubrandenburg (Univ. of Applied Sciences)

Oliver Musshoff, Humboldt University Berlin


Applications of the real options approach hardly consider investment returns to be the result of competitive markets such as markets for agricultural products. The reason is probably that Dixit and Pindyck (1994, ch. 8) show in their very popular book "Investment under Uncer-tainty" that the investment triggers of firms in competitive markets are equal to those of firms with exclusive options. In this study, however, it is shown that this result is restricted to mar-kets in which assets have infinite lifetime. If assets are subject to depreciation and subsequent reinvestment opportunities, competition leads to significantly lower investment triggers. The reason is that depreciation of replaceable assets allows to compensate the potential decline in returns after negative demand shocks because of the non-replacement of depreciated assets. Accordingly, applications of the real options approach to investments in e.g. pig production should consider this effect. The results are obtained by an agent-based simulation approach in which a number of competing firms derive their investment triggers by a genetic algorithm. Since this method allows to understand the resulting price dynamics, an alternative method is presented that allows to simulate the identified price dynamics directly and which also can be used to determine investment triggers for certain conditions.


The Strategic Value of Flexible Quality Choice

Grzegorz Pawlina, Tilburg University, Dept. of Econometrics and OR

Peter M. Kort, Tilburg University, Dept. of Econometrics and OR


This paper analyzes the value of flexibility in quality choice using a dynamic real-option framework. Firms decide about quality of their products when they enter the market upon incurring a sunk cost. Flexibility in quality choice induces (ceteris paribus) earlier investment, and the value of flexible quality increases with demand uncertainty. We find that a possibility of competitive entry more than doubles the relative value of flexibility. Moreover, we show that flexible quality serves as an entry deterrent control, while it can still be set at the optimal monopoly level. Furthermore, we extend the theory of strategic real options from which it is known that the follower's investment timing is irrelevant for the decision of the leader. The addition of a second control (quality) results in the leader's investment timing being influenced by the follower's entry. It also holds that introducing the second control variable in combination with strategic interaction results in the option value of the leader decreasing in uncertainty. Finally, we show that the follower can be driven out of the market due to "aggressive" quality choice of the leader in high states of demand.


3:30 - 5:00 Asymmetric Information, Auctions, and Games

Chair: George Constantinides, University of Chicago


Asymmetric Information and Irreversible Investments with Competing Agents: An Auction Model

Jøril Mæland, Norwegian School of Economics and Business


In this paper real option theory and auction theory is combined. A decision maker has a real option consisting of a right to implement an investment project by paying an investment cost. Two or more agents have private information about the constant investment cost. The owner of the project organizes auction, where the privately informed agents participate. The investment strategy, formulated as an optimal stopping problem, is delegated to the winner of the contract. An optimal compensation function is found, which induces the winning agent to follow the investment strategy preferred by the project owner. It is shown that asymmetric information causes an additional wedge between a
ecting the critical price of implementation, with the inverse hazard rate being a key component.


Real Option Games with Incomplete Information and Spillovers

Spiros Martzoukos, University of Cyprus

Eleftherios Zacharias, University of Cyprus


We model in a game theoretic context managerial intervention directed towards value enhancement in the presence of uncertainty and spillover effects. Two firms face real investment opportunities, and before making the irreversible investment decisions, they have options to enhance value by doing more R&D and/or acquiring more information. Due to spillovers, firms act strategically by optimizing their behavior, conditional on the actions of their counterpart. They face two decisions that are solved for interdependently in a two-stage game. The first-stage decision is: what is the optimal level of coordination between them? The second-stage decision is: what is the optimal effort for a given level of the spillover effects and the cost of information acquisition? For the solution we adopt an option pricing framework that allows analytic tractability.


Strategic Entry and Market Leadership in a Two-player Real Options Game

Mark Shackleton, Lancaster University

Andrianos Tsekrekos, Lancaster University

Rafal Wojakowski, Lancaster University


We analyse the entry decisions of competing firms in a twoÐplayer stochastic real option game, when rivals can exert different but correlated uncertain profitabilities from operating. In the presence of entry costs, decision thresholds exhibit hysteresis, the range of which is decreasing in the correlation between competing firms. The expected time of each firm being active in the market and the probability of both rivals entering in finite time are explicitly calculated. The former (latter) is found to decrease (increase) with the volatility of relative firm profitabilities implying that market leadership is shorterÐlived the more uncertain the industry environment. In an application of the model to the aircraft industry, we find that Boeing's optimal response to Airbus' launch of the A3XX super carrier is to accommodate entry and supplement its current product line, as opposed to the riskier alternative of committing to the development of a corresponding super jumbo.


5:00 - 6:00 Panel Discussion

Moderator: Gil Eapen, Principal, Decision Options, ex Group Director of R&D, Pfizer

High Tech/Corporate Valuation: Challenges and Prospects

Panelists Include

Rainer Brosch (Boston Consulting Group)
Fabio Cannizzo (British Petroleum)
George Constantinides (University of Chicago
Onno Lint (U. Leuven and Associate, Real Options Group)
Michael Raynor (Deloitte Consulting)
David Robinson (Columbia U.)
Rob Smith (Dell Computer Corp).


6:00 - 7:00 Welcome/Networking Cocktail


8:30 - 10:00 Dinner


DAY 2 - Friday July 5

7:45 - 8:30 Continental Breakfast


8:30 - 10:00 Contractual Options and Agency/Incentives

Chair: Apostolos Burnetas, Case Western Reserve University


Adverse Incentives and Real Options: Determining the Incentive Compatible Cost-of-Capital

Carlton-James Osakwe , University of Calgary


In this paper, we examine the real options approach to capital budgeting in the presence of managerial adverse incentives. We show that real options have the potential to be value enhancing or value destroying depending on managerial incentives. We further examine the possibility of using a generic residual income based rule of managerial compensation to induce the proper investment incentives and we seek to determine the cost-of-capital that must be employed in such a rule.


Option Contracts in Supply Chains: Retailer Reorder and Returns Options

Apostolos Burnetas, Case Western Reserve University

Peter Ritchken, Case Western Reserve University


This article investigates the pricing of options when the demand curve is downward sloping. Our specific application arises in a supply chain setting, where a manufacturer offers the retailer the right to reorder items at a fixed price and/or the right to return unsold goods for a predetermined salvage value. We show that the introduction of option contracts causes the wholesale price to increase and the volatility of the retail price to decrease. Conditions are derived under which the manufacturer is always better off by introducing options. In general, options are not zero sum games. In some cases the retailer also benefits while in other cases the retailer is worse off. If the uncertainty in the demand curve is sufficiently high, the introduction of option contracts alters the equilibrium prices in a way that hurts the retailer. Finally, we demonstrate that if either the manufacturer or the retailer wants to hedge the risk, contracts that pay out according to a quadratic function of the price of a traded security are required.


Managerial Flexibility, Agency Costs and Optimal Capital Structure

Ajay Subramanian, Georgia Institute of Technology


This paper investigates the effect of managerial flexibility on the choice of capital structure for a firm and the corresponding valuation of its long term debt. We consider a general model in continuous time where the manager (who is not a shareholder) of a firm with long term debt in place may dynamically switch between different strategies at random times so as to maximize his expected discounted compensation. The manager may bear personal costs due to bankruptcy of the firm and the firm enjoys a tax shield on its interest payments to creditors. Under general assumptions on the nature of the strategies available to the manager, we show the existence of and derive explicit analytical characterizations for the optimal policies for the manager. We then derive the optimal policies for the firm that can hypothetically contract for managerial behavior ex ante, i.e. before debt is in place. We investigate the implications of these results for the optimal capital structure for the firm in the presence of managerial flexibility and the valuation of its long term debt. We also obtain precise quantitative characterizations of the agency costs of debt due to managerial flexibility in a very general context and show that they are very significant when compared with the tax advantages of debt thereby implying that managerial flexibility is a very important determinant of the choice of optimal capital structure for a firm. We carry out several numerical simulations with different choices of underlying parameter values to calculate the optimal leverage, agency costs , corporate debt values and bond yield spreads and study the comparative statics of these quantities with respect to the parameters characterizing the strategies available to the manager. The optimal leverage levels predicted by our model correspond very well with average leverage levels observed in the marketplace.


10:30 - 12:00 Empirical Evidence

Chair: Stathis Tompaidis, University of Texas, Austin


Exercising Real Options: The Case of Voluntary Liquidations

Shumei Gao, Heriot-Watt University School of Management

Anna Eliasson, Hawaii Pacific University

Jihe Song, University of Wales, Abersytwyth


In this paper, we study the option of voluntary liquidations and test the real option model predictions. The results broadly support the presumption that it is performance variability not performance per se, that is important for voluntary liquidation decisions. While evidence for the volatility efefct is strong, evidence for the interest effect is mixed.



Option-based Bankruptcy Prediction

A. Charitou, University of Cyprus

Lenos Trigeorgis, University of Cyprus



Market Imperfections, Investment Optionality and Default Spreads

Sheridan Titman, University of Texas at Austin

Stathis Tompaidis, University of Texas at Austin

Sergey Tsyplakov, University of South Carolina


This paper develops a structural model that determines default spreads on risky debt.  In contrast to previous research, the value of the debt's collateral is endogenously determined by the borrower's investment choice, as well as by a market demand variable that has permanent as well as temporary components. The model also considers market imperfections that limit the borrower's ability to contract to undertake the value-maximizinginvestment choice, and which may in addition limit the borrower's ability to raise external capital. The model is calibrated with data on commercial mortgages, and based on our calibration, we present numerical simulations that quantify the extent to which investment flexibility, incentive problems and credit constraints affect default spreads.


Real Options and Stock Market Anomalies

Han Smit, Erasmus University

Pim van Vliet, Erasmus University


This study presents an intuitive explanation, based on insights of real options theory, for the value size puzzle. Growth-based firms are not overvalued, but priced for their upward risk. Small growth-based firms are especially characterized by an asymmetric risk-return relation. Therefore, the value-size premium comprises two parts: a distress premium and a growth discount. Beta underestimates the risk of distressed firms and overestimates the risk of growth firms caused by asymmetries in stock returns. We examine the impact of growth options on equity returns within a panel of 7,167 listed U.S. firms (1981Ð 2000).


Keynote Luncheon Address

Will Real Options Get the Respect They Deserve?

Gordon Sick, University of Calgary

Professor Sick is Professor of Finance at the University of Calgary. Previously he taught at Yale University, the University of British Columbia, and the University of Alberta. He received a Masters in Mathematics from the University of Toronto, and a Masters and PhD in Finance from the University of British Columbia. Dr. Sick has been a Fellow at the Royal Netherlands Academy of Arts and Sciences (NIAS), and is the book review editor for the Journal of Finance. Professor Sick made early contributions in real options primarily in the area of urban land and natural resource economics and published one of the first comprehensive monographs on real options in 1989. He has made important contributions in the area of certainty-equivalent valuation and capital budgeting, which are at the core of real options. For example, he pondered how to value interest tax shields in the presence of certainty-equivalents, and in his work on Tax-Adjusted Discount Rates he develops the correct treatment for discounting certainty-equivalents (including real options). On the practitioner side, Dr. Sick was one of the founding members of the Real Options Group, and has subsequently consulted independently, for Stern Stewart and Co. and others. He has also been instrumental for the success of the annual real options conference, helping out with the website, program and otherwise.


1:30 - 3:00 Valuation of Electric Power/Infrastructure

Chair: Gordon Sick, University of Calgary


Valuing an Operating Electricity Production Unit

Sigbjørn Sødal, Agder University College

Steen Koekebakker, Agder University College


In this paper we develop an equilibrium-based net present value model of an operating electricity production unit whose supply is given by a stochastic, mean-reverting process. The price process for electricity is derived from an underlying pair of stochastic, aggregate supply and demand processes that are also mean-reverting, while the instantaneous supply and demand functions are iso-elastic. The model is illustrated by a set of experimental data. iso-elastic. The model is illustrated by a set of experimental data.


Real Option Models and Electricity Portfolio Optimization

J. Hlouskova, Institute for Advanced Studies, Vienna-Austria

M. Jeckle, Institute for Advanced Studies, Vienna-Austria

S. Kossmeier, Institute for Advanced Studies, Vienna-Austria


Investments in Thermopower Generation: A Real Options Approach for the New Brazilian Electrical Power Regulation

Katia Rocha, IPEA, Brazil

Ajax Moreira, IPEA, Brazil

Pedro David, FURNAS, Brazil


One of the main questions in electricity market deregulation is the aptitude of private capital for investments in power generation. This is especially important in Brazil, whose load has a strong growth trend (about 5% per year). Thermopower is an attractive alternative for expanding generation, as it is complementary in many aspects to hydropower, which supplies most Brazil's power at a very low price most of the time, but makes the system vulnerable to seasonal water variations. This paper studies the competitiveness of thermopower generation in Brazil under current regulations and assesses under the real options theory approach the conditions for investments in thermopower generation.

Keywords: Stochastic Dynamic Programming; Real Options Theory; Investments in Power Generation.


Optimal Investment Management of Harbour Infrastructures: A Simulation Approach

Carmen Juan, Universidad de Valencia

Fernando Olmos, Universidad de Valencia

J. Carlos Perez, Universidad de Valencia


Most real problems need to be modeled using multiple state variables, combine multiple Real Options (very often american-style ones) and have complex cash flow functions. In this paper we present a new Scenarios-Monte Carlo method to approach this kind of high-dimensional Real Options problems. The method is based on scenarios spaces built at each exercise date so that the payoff function can be modified at each scenario depending on the optionallity. Then scenarios are related in order to calculate the expected value of continuation. The main contribution of the algorithm is that it allows us to price american-style real options while solving decision problems of optimal investment policy.



3:30 - 5:00 Valuation of Flexible Plants and Global Networks via Switching Options

Chair: Ajay Subramanian, Georgia Institute of Technology


(Numerical) Valuation of a Flexible Manufacturing Plant (or FMS): An Overview Using Cost Volume Profit (CVP) Analysis

Giuseppe Alesii, Universita' de L'Aquila, Facolta' di Economia


In this short paper, (Kulatilaka 1988) model of FMS management is reinterpreted as a real options dynamic programming (DP) version of traditional Cost Volume Profit (CVP) analysis. Numerical examples replicate results reported in chapter 4 example 1.H. and chapter 7 of (Dixit and Pindyck 1994). Moreover, a different version of (Kulatilaka 1988) numerical example is analyzed. Results include not only the value of the flexible plant, decomposed into its base value and the value of the flexibility options (namely abandonment option, production mode switching option, mothballing option and waiting to invest option), but also mode bounds (threshold curves) are derived not only for the beginning time but for the whole life of the project. In conclusion, this paper shows how much powerful is Kulatilaka's General Real Option Pricing Model (GROPM) in reaching through simple numerical methods results that others, (e.g. Dixit and Pindyck 1994), get through very difficult symbolic stochastic algebra.



Valuation of a Flexible Plant with Staging Flexibility and Multiple Production Modes

Spiros Martzoukos, University of Cyprus

N. Pospori, University of Cyprus

Lenos Trigeorgis, University of Cyprus



Real Switching Options and Equilibrium in Global Markets

Ajay Subramanian, DuPree College of Management, Georgia Institute of Technology

Nagesh Murthy, DuPree College of Management, Georgia Institute of Technology

Milind Shrikhande, J. Mack Robinson College of Business, Georgia State University


This paper proposes and investigates a theoretical model in continuous time to analyze the real switching options that an economic entity in relationships with multiple external economic agents holds and the corresponding implications for equilibria between the entity and the agents if they are active. Although our basic model is generally applicable in several widely different economic scenarios, for expositional simplicity, we consider the specific problem of a firm and its global suppliers. We begin by considering the optimal dynamic policy problem for the firm where it may face different exogenously specified relationship specific fixed costs and random variable costs vis-›-vis each supplier and its goal is to dynamically choose a supplier over time so as to maximize its expected discounted cash flows. At any instant of time, the firm therefore holds compound real options of entering the market with a particular supplier, switching to another supplier or exiting the market. In the case where the firm has two suppliers, we derive necessary and sufficient conditions on the fixed and variable cost structures of the firm vis-›-vis the suppliers for the switching option of the firm to have strictly positive value. These also represent necessary and sufficient conditions for each supplier to have strictly positive expected cash flows. Either one of the two suppliers captures the market if these conditions do not hold. We illustrate our analytical results through several numerical simulations. Next, we investigate the equilibria between the firm and its suppliers when both suppliers are in the same foreign country (or, more generally, in two countries with pegged currencies) with uncertainty driven by fluctuations in the exchange rate process. The prices quoted by the suppliers and, therefore, the variable costs of the firm are now determined endogenously in equilibrium where the suppliers and the firm respond rationally and optimally to each other's policies. We devise a procedure to derive equilibria between the firm and its suppliers where a leader-follower game between two competing suppliers allows the firm to maximize value given its bargaining power. We provide sufficient conditions for both suppliers to co-exist in any possible equilibrium with the firm. We identify equilibria between the firm and its suppliers for several different values of underlying parameters that illustrate the impact of competition in global markets.



8:00 - 8:30 Welcome/Overview Talk (by Paphos port & castle)

Overview of Cyprus Financial System & European Prospects

Dr. Marios Clerides, Chairman, Cyprus Securities & Exchange Commission


8:30-10:00 Reception by Paphos port & castle, followed by free stroll near Paphos port & downtown


DAY 3 - Saturday July 6


7:45 - 8:30 Contintental Breakfast


8:30 - 10:00 Conceptual I: Overview, Track I Akamas Ballroom A

Chair: Richard Schockley, Indiana University


Real Options Analysis and the Assumptions of the NPV Rule

Richard Schockley, University of Indiana

Tom Arnold, Louisiana State University


The point of this paper is to spell out in layman's terms the assumptions that underlie DCF analysis, the NPV rule, and the 'unanimity' result. In order to use financial-market prices to value new corporate investments, we have to assume that the financial markets are free of arbitrage opportunities and that the new investment does not change the equilibrium price system. This latter assumption was called the 'competitivity' assumption in the unanimity literature, and it amounts to an assumption that the financial markets are complete and that the new investment does not change aggregate consumption in a material way (if either is violated, the new investment changes the equilibrium in the financial markets and hence changes all prices, so the NPV rule is not the unanimous decision rule - see Baron's review article in JF, 1979). Of course if markets are complete and free of arbitrage opportunities, then a unique EMM prices all assets. Hence, the assumptions needed to apply the NPV rule are sufficient for application of option pricing techniques to real assets.


Extended NPV and Real Options with Information Uncertainty: Applications for R&D and Ventures

Mondher Bellalah, (Universite Cergy and Universite Paris-Dauphine, France


This paper presents a survey of some results regarding the standard discounted cash flow techniques, the economic value added and real options. Since the standard literature ignores the role of market frictions and the e¥ect of incomplete information, we rely on MertonÕs (1987) model of capital market equilibrium with incomplete information to introduce information costs in the pricing of real assets. Using this model instead of the standard CAPM allows a new definition of the weighted average cost of capital and o¥ers some new tools to compute the value of the firm and its assets in the presence of information uncertainty. Using the methodology in Bellalah (2001 a,b) for the pricing of real options, we propose some new results by extending the standard models to account for shadow costs of incomplete information. The extended models can be used for the valuation of R&D projects as well as projects with several stages like joint ventures.


Real Options and Game Theory: When Should Real Options Valuation be Applied?

Helen Weeds, Lexecon


In recent years there has been considerable interest in real options as a valuation method and investment appraisal technique. In addition to a multitude of specialist textbooks (see, among others, Trigeorgis (1996), Amram and Kulatilaka (1999) and Copeland and Antikarov (2001)), the real options approach is also now covered in standard texts such as Brealey and Myers (2000). The technique has been applied to a number of areas including valuation of oil leases, patents and real estate.

Despite initial enthusiasm, real options valuation has proved difficult to put into practice. The techniques are significantly more complex than the established investment appraisal methods of discounted cashflow (DCF), return on capital employed (ROCE) or payback period. Real options valuation requires detailed analysis of all possible future developments, and the degree of uncertainty surrounding these possibilities, not just the expected outcome. Managers are also required continuously to monitor the development of the business environment, considering whether conditions merit the exercise of a further investment opportunity, or whether they have deteriorated so far that abandonment of the project is now advisable.

Even assuming that these practical difficulties can be overcome, a fundamental issue remains to be resolved. When exactly should real options be applied? Is it always relevant, or are there situations in which the established DCF-based methods are superior? There are, even consultants selling the technique will admit, situations where real options could lead a firm seriously astray. In a setting where there are strategic advantages to acting quickly and seizing the advantage over oneÕs rivals, the use of real options could cause a firm to miss important an opportunity and relinquish its position in the market.

How can we identify the situations in which real options should be abandoned in favour of more established techniques? Difficulties arise particularly when real options interact with strategic interactions between firms. There is a crucial gap in this area, causing considerable confusion. This article aims to shed some light on this issue and provide some guidance as to the market conditions under which real options valuation, or a DCF-based technique, should be applied.


8:30 - 10:00 Conceptual II: General Perspectives, Track II (Akamas Ballroom C)

Chair: Lawrence Kryzanowski, Concordia University


Action Flexibility or the Option to Use Real Options: A Neo-institutional Economics Perspective

Marcus Dimpfel, University of St Gallen, Switzerland

Rene Algesheimer, University of Mainz, Germany


Neither the theoretical nor the more practice oriented publications in the field of real options theory attach much value to the preliminary decision whether or not to apply real options theory in principal to a specific context. Most often it is assumed that action flexibility is indeed of great importance for a setting and that therefore corporations have already voted for the implementation of real option theory. As a consequence most of the contributions focus on the detailed execution of the real options approach. Only a minority of authors comprises the preliminary decision, but most often remains on a very abtract level, stating that the relevance of action flexibility and therefore the principal application potential of real options theory is the higher, the higher an investment context's uncertainty is.

In this paper we therefore first of all substantiate the abstract constructs of uncertainty and irreversibility which together drive the relevance of action flexibility in principal. Furthermore we outline that the relevance of the different categories of action flexibility, respectively real options, are influenced in different manners by the determinants uncertainty and irreversibility.

On the basis of this paper, companies have a much better guideline to assess the principal application potential of real options theory for an investmentÓs context. Furthermore they get valuable insights with respect to the categories of real options they should focus on. This fact seems especially important as the different real option categories require diverse models and approaches.


Real Options Valuation of Companies Run by Theory of Constraints

Ricardo Rochman, FGV-EAESP, Brazil


The valuation of companies managed by theory of constraints is difficult due to the flexibilities inherent to the system, like the exploration of new markets, the expansion or shrinkage of production, the modification made in the products, etc. Traditional valuation models like the net present value or discounted cash flow do not work suitably because they ignore the flexibility management has to revise its decisions. So we present a framework using real options valuation, more specifically the binomial model, to value the company because it considers the flexibilities of the system and has the assumption that management is proactive. The correct use of both theories together result in optimization of decision making in the short and long run and the consequent creation of value for the shareholders.


On Property Rights and Appropriation of Real Options

J.P. Dapena Fernandez, Universitad del CEMA, Argentina


Property in financial options (derivatives) is stated and transferred through contracts, while in real options property may arise from assets under the management of the firm, without a formal contract properly defining property. Furthermore, in some situations the asset can be public, and its property shared among different agents or firms. The present paper intends to work on the mechanisms of appropriation (and hence transferability) of real options exploring the assets that give rise to them, and proposing the concept of indirect property of complementary assets. The meaning of property is explored, and also the dynamic of change between public and private assets. Finally, we develop on the features that define real options stemming from the indirect property of complementary assets.


10:30 - 12:00 Economic Models of Real Options Valuation, Track I Akamas Ballroom A

Chair: Tim Folta, Purdue University


Valuation of Football Players

R. Tunaru, Middlesex University

Ephraim Clark, Middlesex University

H. Viney, Middlesex University


Timing and Scaling Options for Market Power with Application to Real Estate: When and How Much to Invest?

Sigbjørn Sødal, Agder University College


We develop a model of the investment behavior of a firm that faces a stochastic, downward-sloping demand curve. The firm's challenge is to determine the optimal scale and time of an investment, so there is a potential for market power in the sense of markup pricing along two dimensions: static market power along a quantity dimension, and dynamic market power along a time dimension. Depending on the specific assumptions, either dimension will be more or less relevant. For example, the option to wait may be useless if the uncertainty of demand is low and the demand curve is not very elastic. Then the decision of the firm simplifies to that of a standard monopoly model. In other cases, the option to wait prevails. Typically, the latter happens when there is much uncertainty and the demand curve is fairly elastic. The formal model is illustrated by decisions in the real estate industry.


Investment and Abandonment Under Economic and Implementation Uncertainty

Andrianos Tsekrekos, Lancaster University


We examine the optimal investment and abandonment policy for a firm that contemplates a project exposed to two sources of uncertainty: one over the economic returns of the venture and the second concerning the actual implementation of the project. We provide a general way of introducing implementation uncertainty which includes prior research as special cases. The generality of our treatment stems from the fact that implementation uncertainty is allowed to affect both the level and the timing of project profitability. When compared to their Marshallian counterparts, the optimal policy thresholds can imply earlier or later investment and abandonment, depending on parameter values. In two simplified cases explicitly addressed, a firm might invest earlier or abandon a project later depending on whether implementation uncertainty is expected to be resolved favourably or not.


Entry Timing in the Presence of Growth Options

Tim Folta, Purdue University

Jonathan O'Brien, Purdue University


This paper investigates the influence of industry uncertainty on the decision by established firms to enter a new industry. Specifically, we examine the tension between the option to defer, which discourages entry in the presence of uncertainty, and the option to grow, which may encourage entry in the presence of uncertainty when there are early mover advantages. Empirical analysis on data from a broad array of industries revealed that the effect of uncertainty is not monotonic, and that inflection points are influenced by factors that should theoretically influence the value of the option to grow and the option to defer.

Keywords: uncertainty, growth option, real option, entry, early mover advantages


10:30 - 12:00 Theoretical Issues I, Track II (Akamas Ballroom C)

Chair: Manuel Rocha Armada, U. Minho, Portugal


Fuzzy Real Option Valuation

M. Collan, IAMSR/Abo Akademi U., Finland

P. Majlender, IAMSR/Abo Akademi U., Finland


An Extension of Least Square Monte Carlo Simulation for Multi-option Problems

Andrea Gamba, University of Verona


This paper provides a new approach for valuing a wide set of capital budgeting problems with many embedded real options dependent on many state variables and a related valuation algorithm based on Monte Carlo simulation. The valuation approach decomposes a complex real option problem with many options into a set of simple options, and properly taking into account deviations from value additivity due to interaction and strategical interdependence of the embedded real options, as noted by Trigeorgis (1993). The valuation approach presented in this paper is an alternative method to the general switching approach for valuing complex option problems, as proposed by Kulatilaka and Trigeorgis (1994) and Kulatilaka (1995). The related numerical algorithm is based on simulation, along the lines of Longstaff and Schwartz (2001), and is extended in order to implement the decomposition approach. We provide also an array of numerical results to show the convergence of the algorithm and a few real life capital budgeting problems, to see how they can be tackled with our approach.


Real Investment Opportunity Valuation and Timing with Finite-Lived American Exchange Options

Paulo J. Pereira, U. Minho, Portugal

Manuel Rocha Armada, U. Minho, Portugal

Lawrence Kryzanowski, Concordia University


In practice, the investment opportunities that can be delayed are more like exchange than simple call options, because there are uncertainties both in the gross project value (underlying asset) and in the investment cost (exercise price). Companies that have the option to invest at anytime until a certain date (the maturity), also often have some opportunity costs (the lost cash flows) in holding the option instead of the project. Incorporating these aspects leads to a more realistic evaluation process. In this research, we value three real investment projects as finite-lived American exchange options, correcting and applying the Carr (1988) model. We conclude that, as expected, the traditional Net Present Value method substantially undervalues projects with this kind of flexibility (excluding those that are deep in-the-money). This leads to wrong decisions about the timing of these investments. We also conclude that the results from using the corrected 1988 Carr model differ substantially from those that we obtain from using the uncorrected version. As expected, the corrected model gives results that are higher in value.
Keywords: Real Options; Investment Under Uncertainty; Deferment Option; Exchange Options.


1:30 - 3:30 Valuing Natural Resource Investments, Track I Akamas Ballroom A

Chair: Marco A.G. Dias, Petrobras


Real Options Analysis of the Capital Structure of East Rand Proprietary Mine: A Case Study

M. Samis, Kuiseb Consulting


Valuation of Commodity Projects and the Option to Invest with Stochastic Prices and Incomplete Information

Mondher Bellalah, Universite Cergy and Universite Paris-Dauphine, France


This article extends the three models in Schwartz (1997) to describe the stochastic behavior of commodity prices in the presence of mean reversion and shadow costs of incomplete information. The implications of the models are studied with respect to the valuation of financial and real assets. We extend the analysis in Schwartz (1997) to account for the effects of shadow costs of incomplete information as defined in Merton (1987).

The first one-factor model assumes that the logarithm of the spot commodity price follows a mean reverting process. The second model is a two-factor model in which the convenience yield is stochastic. The third model accounts for stochastic interest rates. The implications of the models are studied for capital budgeting decisions.

We develop also a one-factor model for the stochastic behavior of commodity prices which preserves the main properties of more complex two-factor models. When applied for the valuation of long-term commodity projects, the model gives practically the same results as more complex models.

Investment in Information in Petroleum: Real Options and Revelation

Marco A.G. Dias, Petrobras


A firm owns the investment rights over one undeveloped oilfield with technical uncertainty on two parameters, the size and quality of the reserve. In addition, the long run expected oil price follow a stochastic process. The modeling of technical uncertainty uses the practical concept of revelation distribution, which works directly with the possible new expectations after the information revelation. Expectations drive the valuation of the development option exercise. With a partial revelation of uncertainty of a technical parameter, is necessary to know only the initial uncertainty (prior distribution) and the expected reduction of the uncertainty caused by the information, in terms of percentage of variance reduction. After the information revelation, the development threshold decision depends on the value of the project level normalized by the development cost, and this normalized threshold is the same for any technical scenario revealed by the new information when the oil prices follows a geometric Brownian motion. In addition, there is a time to expiration of the rights for development, so that the normalized threshold is a free boundary obtained from the optimal stochastic control theory. The model includes a penalty factor for the lack of information, which causes non-optimized development. It is quantified using discounted cash flow and this factor is introduced into the dynamic real options model. The model outputs are the real options value with and without the technical uncertainty, and with and without the information. This permits to estimate the dynamic net value of information. Keywords: value of information, dynamic value of information, real options, investment in information, information revelation, revelation distribution, Monte Carlo simulation, optimization under uncertainty, valuation of projects.


Real Options for the Release of New Crude Mixtures in Mexico

Angel Soriano-Ramirez, Mexican Institute of Petroleum

Myriam Cisneros-Molina, Mexican Institute of Petroleum

Carlos Ibarra-Valdez, Autonomous Metropolitan University, Mexico


Blending operations are widely used in industrial plants including oil refineries, chemical plants, and cement plants. The operation mixes two or more streams with different properties to a given specification (e.g. temperatures, quality, etc.). The problem of optimal blending has been widely treated, mainly with a mathematical control theory point of view. In Mexico, blending problem is of utmost importance. The three types of crude that PEMEX (a government-run company in charge of oil extraction, commercialization, management and administration of oil and its derivatives) currently delivers are: Olmeca, Itshmus and Maya. They all are mixtures and their sales represent an important income for the country. The differences between them are mainly in the API gravity characteristic among others. Up to date, the mixture procedure in PEMEX has not been fully systematized and it still requires partially processes of a handicraft nature. A recent work (Alvarez-Ramirez et al, 2001) has shown a better procedure for optimizing the way the mixture can be done keeping the desired characteristics. This methodology is based on the introduction of Robust Updating Controllers. Approaching the basic scheme in the above mentioned work, there are some points at which seems to be worth considering real options techniques, namely, for introducing new crude oil mixtures for commercialization in Mexico and getting optimal timing for release. The aim of this work is applying real options techniques to obtain conclusion about the optimal release timing of feasible new crude oil mixtures of Mexico crudes. This includes modeling some of the principal variables involved in the commercialization of a crude oil mixture. On one hand, the consideration of the problem involves taking into account the uncertainty of the Mexican crude mixture prices, the possible price dynamics of new products, their possible demand and supply, the characteristics of inputs, and considering the inventories. On the other hand, it requires the assessment of the following investment decision options: deferring, expanding, contracting, shut down, restarting, abandonment, switching, and relinquish, among others. These options are considered in the blending procedure as well as in the commercialization for the new products. Keywords. Crude oil blending; Crude oil commercialization; real options.


1:30 - 3:30 Theoretical Issues II, Track II Akamas Ballroom C

Chair: Spiros Martzoukos, University of Cyprus


Limits of Integrating Taxes in Real Option Theory

Caren Sureth, University of Bielefeld

Rainer Neimann, University of Tübingen


It is well known in the theory of capital budgeting that taxes may have a significant impact on investment decisions. Since real options are now widely accepted for assessing investment projects in financial theory as well as in business practice, it is straightforward to integrate taxation into real option-based models. By doing so, it is possible to derive a post-tax investment rule and to identify tax-induced investment distortions. Consequently, real options literature has been enriched by some recent publications on taxational issues [e.g., Mauer and Ott (1995), Harchaoui and Lasserre (1996), Alvarez and Kanniainen (1997), Jou (2000), Pennings (2000), Agliardi (2001)]. Nevertheless, neither the pre-tax models nor the integration of taxes follow a unified pattern. Therefore, these approaches are not applicable to draw general conclusions concerning the influence of taxation on investment behavior.


Real Options with Incomplete Information and Time-To-Learn

N. Koussis, University of Cyprus

Spiros Martzoukos, University of Cyprus

Lenos Trigeorgis, University of Cyprus


Valuing Projects with Stochastic Asset Life

Jihe Song, The University of Wales, Aberystwyth

Huw Rhys, The University of Wales, Aberystwyth


In this paper we propose a stochastic model of asset life under unceratinty when there is a resale option. We distinguish asset activity life, economic life and physical life and model activity life as the expected first passage time distribution for geometric Brownian motion to an optimal resale boundary. We also establish three convergence results on asset economic life as the sum of (1) Independent inverse lognormal distributions; (2) Inverse lognormal and Poisson distributions; (3) Dependent random variables. Using real options theory and generlaised Central Limit Theorems, we demonstrate the expected economic life of a durable asset. We have extended the deterministic model of asset life to the uncertainty case. Our results throw new lights on the market for used goods and extend the applicability of real options approach.


Valuation of Options on Multiple Operating Cash Flows

Antonio Camara, Strathclyde University


This paper establishes a risk neutral valuation relationship (RNVR) for the pricing of options on multiple operating cash flows assuming that there is a representative agent who has an extended power utility function. Aggregate consumption and the underlying operating cash flows are multivariate displaced lognormal distributed. This RNVR is applied to obtain closed-form expressions for the value of a new class of investment options, the event-contingent options. The formulae maintain the risk neutrality characteristic of the Black-Scholes model, and depend on the threshold parameters of the underlying cash-flows. The threshold parameter is the lower bound of the underlying stochastic variable. A negative threshold parameter assigns a positive probability to both inflow and outflow events. The paper also offers examples of event-contingent options in a global context.


3:30 - 4:30 Panel Discussion

Moderator: Gordon Sick, University of Calgary

Current State, Challenges and Future Prospects

Panelists Include:

Marco A.G. Dias (Petrobras)
Tim Folta (Purdue U.)
Arnd Huchzermeier (WHU Koblenz)
John Kensinger (U. N. Texas)
Lawrence Kryzanowski (Concordia U.)
Lenos Trigeorgis (U. Cyprus and ROG)
Helen Weeds (Lexecon Inc.)


4:30 Closing Remarks/Conference Concludes

8:30 - 10:30 Traditional Dinner with Music (downtown)

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