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8th Annual International ConferenceMontréal
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DAY 1 - THURSDAY, JUNE 17 |
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Registration |
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Empirical Evidence |
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Case Applications & Public Policy |
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Panel Discussion (joint): |
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Networking Reception Sponsored by |
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DAY 2 - FRIDAY, JUNE 18 |
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Track I |
Track II |
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Registration & Breakfast |
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President's Address |
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Conceptual/Practical |
Strategic Decisions/Valuation |
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Commodities/Resources |
Competition and Strategy |
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Luncheon Address by |
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Valuing Power Investments |
Competition and Games |
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Infrastructure/Networks |
Valuation Issues |
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Keynote Address by |
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DAY 3- SATURDAY, JUNE 19 |
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Track I |
Track II |
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Breakfast |
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Technology Investments |
Theoretical Issues |
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Agency Issues |
Computational |
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Panel Discussion: |
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Empirical Evidence
Chairperson: Jeffrey Reuer,
1:30 PM
Corporate Investment Decisions
and the Value of Growth Options
Jeffrey Reuer,
Abstract
Recent applications of real options theory in strategy research have
examined investment decisions framed as the purchase or exercise of
particular options, but research has yet to offer direct evidence on whether
firms actually capture option value from such investments. In this paper, we
estimate the proportion of firm value accounted for by growth options and
link the growth option value to corporate investments that have been commonly
viewed as providing valuable growth options. The empirical analysis examines
internal and external corporate development activities of a panel of 293
manufacturing firms during 1989-2000. The results indicate that investments
in research and development and in joint ventures contribute to growth option
value, and that investments in tangible capital and in acquisitions have no
effect in general. Notably among equity joint ventures of various ownership
levels, only minority joint ventures have significant effects.
1:55 PM
Investor
Valuation of the Abandonment Option: Empirical Evidence from UK Divestitures
Ephraim
Magid Gadad,
Finance Institute of
Patrick Rousseau, U. Aix-Marseille
Abstract
This paper looks at divestitures by 144
Keywords: real options, abandonment, divestiture, premature abandonment, abnormal returns.
JEL Classification: G13, G33, G35, M41
2:20 PM
Empirical Testing of Real Options
in the Hong Kong Residential Real Estate Market
Huimin Yao, U.
Hong Kong
Frederik PRETORIUS, U. Hong
Kong
Abstract
Thursday
Case Applications and Public Policy
Chairperson: Jean-Daniel Saphores, U.
3:15 PM
Architectural Flexibility: A
Case Study of the Option to Convert to Office Space
Leon Glicksman, MIT
Abstract
Corporate facility managers and real estate developers recognize the
potential value in flexible spaces. Investments in architectural flexibility
are currently guided by client intuition and refined by the architect's
knowledge of specifications allowable within the realm of building codes and
the applicable costs. More formal valuation of flexibility in architectural
design would help inform rational levels of investment in the design process
and resulting construction to address rel
Grandma
or the Wolf?: Managing Human-Wildlife Conflict
Baishali Bakshi,
U.
Jean-Daniel Saphores, U.
Abstract
As wildlife habitats shrink, some species are pushed into extinction,
while conflicts with others increase and cause significant economic damages.
This paper proposes a simple real options framework to analyze wildlife
management policies that account for ecological uncertainty and the risk of
extinction. Our application to wolves provides an economic justification for
their reintroduction and highlights the importance of existence value. Our
sensitivity analysis shows that the optimal management policy depends on the
growth rate, the volatility, and the minimum viable density of the wolf
population, but little on damages, existence value, and the discount rate for
the parameters considered.
4:05 PM
Private Investment in
Biodiversity Conservation
Dagmar Mithoefer,
U. of Hannover
Justus Wesseler, Wageningen U.
Hermann Waibel, U. of Hannover
Abstract
In the 1990's, the World Agroforestry Centre
(ICRAF) initiated a domestication programme of indigenous fruit trees (IFTs) in
(1) fruit collection cost and/or
(2) the necessary technical change, i.e. breeding progress, have to rise that
will render tree planting economical.
Results show a combination of technical change and decrease in resource
abundance provides scope for farmer-led planting of domesticated IFTs and bio-diversity conservation. However, breeding
progress must be significant for investment in tree planting to be
economically attractive and thus to contribute towards on-farm preservation
of the IFTs.
Keywords: biodiversity, CAPM, real option, R&D, technology adoption,
Thursday
Panel Discussion
Chairperson: Blake Johnson,
Vladimir Antikarov, Monitor Group
Rainer Brosch,
Gil Eapen, Decision Options LLC
Scott Matthews, Boeing Corp.
Thursday
Networking Reception Sponsored by CIRANO & CIREQ and ROG
Registration and Breakfast
Friday
Chairperson's Welcome
Chairperson: Marcel Boyer, U. Québec - Montréal, CIRANO & CIREQ
Friday
President's Address
Chairperson:
Friday Track I
Conceptual & Practical
Chairperson: James Alleman,
8:30 AM
Real
Options and the Theory of the Firm
Ellen Roemer, U. Paderborn & U
Abstract
Real options analysis is a research field that spreads across different academic
disciplines. In recent times, real options analysis is more and more
advancing into the domain of strategic management. In this respect, it can be
observed that an increasing number of papers is
dealing with real options analysis in combination with organizational
questions. In this paper, I investigate the organizational decision how real
options should be aligned: by market coordination, by hierarchical
coordination or by intermediate coordination. I explore to what extent real
options analysis can support such organizational decisions. More precisely,
the research question is how real options analysis can be contribute to
determine whether real options should be organized out outside the firm,
inside the firm or in intermediate forms of coordination. Therefore, I sketch
the foundations of real options analysis and I briefly summarize Transaction
Cost Economics as one approach to explain the boundaries and the existence of
firms. Moreover, I compare the two approaches in order to demonstrate parallels
and divergences as a basis for a discussion of real options and decisions of
economic organization. Subsequently, I discuss different types of uncertainty
along with different types of options. I point out how real options should be
organized to maximize the value of the firm. The paper closes with some
critical remarks and ideas for future research.
Rules of Thumb in Real Options
Analysis
Giuseppe Alesii, U. de L'Aquila, Italy
Abstract
In this normative paper we derive payback period (PBP) and internal rate
of return (IRR) in the presence of real options. In a Kulatilaka
- Trigeorgis General Real Option Pricing Model, we derive the expected value
of these two decision rules that corresponds to the expected NPV Bellman
dynamic programming maximizing strategy in the presence of the options to
wait, to mothball and to abandon. A number of original results are derived
for an all equity financed firm. Expected PBP and IRR at time 0 are derived
together with their distribution. These new methods are applied to a case
study in shipping finance. Real options are shown to be value enhancing and
shortfall decreasing also with respect to thumb rules: expected IRR is
increased while expected PBP is decreased. Probabilities of earning negative
returns are reduced together with those of not recovering initially invested
capital. Our model gives a more intuitive insight into the dynamic optimal
behavior which is endogenous to real options valuation models showing plainly
how the representative agent would probably manage optimally her project.
This would help to compare optimally dynamic behavior with current practice
and to conclude whether real options are a simple pure academic abstraction
or a realistic model.
9:20 AM
The
Option to Sell a Real Asset and the Grace Rate Rule
Meir Fradkin,
Abstract
This paper explores an option to sell a real asset (a put option on a real
asset), under general assumptions accepted in the literature about investment
under uncertainty. First, general differential equation for the put option
value is derived, and appropriate boundary conditions are spelled out. Next,
a behavior of this real option value is examined, while looking at this value
as a function of asset's parameters, such as volatility of cash flows, and a
discount rate. Then, as an analog for the hurdle rate rule in case of
investing in the real asset, the 'grace rate' rule is introduced as a proxy
for the optimal selling (scrapping) decision. The finding is that, similarly
to the hurdle rate rule, the 'grace rate' rule is robust enough, and may lead
to a near optimal decision for a wide range of the project's parameters.
9:45 AM
An Investment Decision-Making
Criterion Incorporating Real Options
James Alleman, U. of Colorado - Boulder
& Columbia U.
Hirofumi Suto, NTT East, Tokyo, Japan
Paul Rappoport, Temple University, Philadelphia,
PA, USA
Abstract
This paper provides an investment decision-making criterion under
uncertainty using real options methodology to
Keywords: Real Options, Investment Decisions, Present Value, Project Valuation
Friday Track II
Strategic Decisions/Valuation
Chairperson: Pierre Mella-Barral,
Valuing a Start-Up Firm: Creative
Destruction and Real Options
Cecilia Maya, U. EAFIT,
Abstract
In this paper I propose a Creative Destruction - Real Options Approach
(CD-ROA) to valuing start-ups when only technological uncertainty is present.
I claim that is the case when a company takes part of a Creative Destruction
process as described by Schumpeter (1942). This approach is able to explain
the high prices investors pay for growth stocks and proves that it is not a
case of overpricing but recognition of the large growth potential of firms
which are part of highly innovative industries. I also perform a case study
on the valuation of Gilead Sciences, Inc., using the CD-ROA.
Valuing a Leveraged Buy-out
Francesco Baldi,
Abstract
The leveraged buy-out is a financial technique that consists in the acquisition
of the majority of a firm by a group endowed with entrepreneurship, composed
of private investors or institutional investors or merchant banks or by all
three subjects together, mostly financed by debts, destined to be paid back
using the financial resources produced by the firm itself in the form of Free
Cash Flows from Operations or divestments of non-strategic activities as well
as assets and shares as side guarantee to obtain the loan itself . The aims
of the team of the buyers are two:
1) valuate the target firm, that is fix the top price they are
willing to pay to the vendor to buy the firm;
2) examine the options of different nature that shareholders and
management will have during the administration of the target firm and the
interactions that, probably, will be established with each other in order to
include them in the determination of the economic value.
These aims shall be reached considering that the problem to be faced may be
divided into three steps:
a) organize the Newco's financial
structure getting the quantity of debt necessary to carry out the acquisition
from banks and bondholders;
b) pay back the contracted debts within the due date,
avoiding insolvency;
c) reorganize the target firm's structure in order to improve
the business performance and to assure, if not to accelerate, the
reimbursement of the debt by means of larger Free Cash Flows from Operations.
The paper is organized as follows. First, we describe the main
characteristics of a leveraged buy-out structuring process as well as the
traditional approach usually applied to perform the valuation of the target
firm represented by the Adjusted Present Value pure method. Second, we
propose a correction of the Adjusted Present Value method by means of an integrative
use of the Real Option Approach. In particular, we identify two real options
that may be considered inherent in a leveraged buy-out technique: a financial
default option and an operating default option. The expansion of the firm
value is accomplished relying on the common roots existing between the NPV
analysis and the Discounted Cash Flow method. So it is possible to pass from
a passive equity value to the equivalent expanded value and transform the
valuation of the target firm from passive to dynamic through the merger, in
the process of managerial choices and so, also in the valuation process, of
real options. The result of the suggested integration is called Expanded
Equity Value. Finally, a business case is reported in order to illustrate our
reasonings.
9:20 AM
Knowhow
Acquisition in the Formation and Duration of Joint Ventures
Pierre Mella-Barral,
Michel Habib,
Abstract
We analyze the role of knowhow acquisition in
the formation and duration of joint ventures. Two parties become partners in
a joint venture in order to benefit from each other's knowhow.
Joint operations in the joint venture provide each party with the opportunity
to acquire part or all of its partner's knowhow. A
party's increased knowhow provides the impetus for
the dissolution of the joint venture, as it decreases the need for the
partner's knowhow. Dissolution takes the form of
the buy out of one partner by the other. We characterize the conditions under
which such dissolution takes place, identify the party that buys out its
partner, determine the expected time to dissolution and various measures of
uncertainty regarding that time, establish its comparative statics, and examine the implications of knowledge
acquisition for the desirability of joint venture formation.
9:45 AM
The Value of Flexibility in
Sequencing Growth Investments
Peter Kort,
Pauli Murto,
Grzegorz Pawlina,
Abstract
We analyze the investment decision of a firm which has an option to
complete an investment project in two stages instead of undertaking it at a
single point in time. The firm faces a trade-off between this additional
flexibility and the total cost since completing the investment in two steps
is more costly. We derive the optimal investment rule and show that higher
uncertainty makes the lump investment more attractive than the sequential investment.
Furthermore, we derive the optimal fraction of the project to be invested in
the first and the second stage and obtain that the optimal size of investment
in the first stage is positively related to uncertainty. Finally, despite the
fact that higher uncertainty favors the lump investment, we show that it can
make the sequential investment more likely. We illustrate our model with a
case study and calibrate its parameters using actual market data.
Friday Track I
Valuing Commodities & Natural
Resources
Chairperson: Jaime Casassus, PUC -
10:30 AM
Optimal Investment Scale and
Timing in Oilfield Development
Marco A. G. Dias, Petrobras &
PUC - Rio de Janeiro
Katia Rocha, IPEA & PUC -
Rio de Janeiro
José Paulo Teixeira, PUC - Rio de
Janeiro
Abstract
The oil company holds the investment opportunity to develop a delineated
oilfield. The investment plan must be presented until a specific date or the
oilfield rights return to the government. The firm considers a set of
mutually exclusive alternatives of scale to exploit the oilfield. Larger
scale means faster exploitation, increasing the present value of revenues,
but also higher investment cost. Oil price uncertainty affects all alternatives.
In addition to the scale option, the firm has a timing option and hence this
investment opportunity is analog to a finite-lived American call option on
the best of multiple assets with the same underlying oil price stochastic
process but with different benefits and different exercise prices. We examine
both geometric Brownian motion and a mean-reversion process to model oil
prices. We obtain the undeveloped oilfield (real option) value and the
optimal investment rules, i.e., the optimal timing and the optimal scale
thresholds.
Operating
Options and Commodity Price Processes
Manle Lei,
Glenn Fox,
Abstract
This paper discusses the short-run dynamics of commodity prices. It deals
with the interrelationships between price, inventory and price volatility as
well as the effects of inventory and the producers’ operating
flexibility on the dynamics of price in the short-run. It also illustrates
how to model and estimate the stochastic process of commodity prices. We
conclude that, in the short-run, producers’ operating flexibility
reduces price volatility when the spot price is higher than the threshold price
causing expansion in the scale of operations. However, we also conclude that
operating flexibility can increase price volatility when the spot price is
lower than the threshold price resulting in a contraction of operations. We
demonstrate the failure of currently used parametric models in describing the
stochastic process of commodity prices and suggest using non-parametric
methods. We also recommend including the time trend in such a model.
Valuation of Commodity Options
and the Option to Invest with Incomplete Information
Mondher Bellalah, U. de Cergy - France
Abstract
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.
11:45 AM
Equilibrium
Commodity Prices with Irreversible Investment and Non-Linear Technologies
Jaime Casassus, PUC -
Pierre Collin-Dufresne, U.
Abstract
We model the properties of equilibrium spot and futures oil prices in a
general equilibrium production economy with two goods. In our model
production of the consumption good requires two inputs: the consumption good
and a Oil. Oil is produced by wells whose flow rate
is costly to adjust. Investment in new Oil wells is costly and irreversible. As
a result in equilibrium, investment in Oil wells is infrequent and lumpy.
Equilibrium spot price behavior is determined as the shadow value of oil. The
resulting equilibrium oil price exhibits mean-reversion and heteroscedasticity. Further, even though the state of the
economy is fully described by a one-factor Markov process, the spot oil price
is not Markov (in itself). Rather it is best described as a regime-switching
process, the regime being an investment `proximity' indicator. Further, our
model captures many of the stylized facts of oil futures prices. The futures
curve exhibits backwardation as a result of a convenience yield, which arises
endogenously due to the productive value of oil as an input for production.
This convenience yield is decreasing in the amount of oil available in the
economy. We test out model using crude oil data from 1982 to 2003. We
estimate a linear approximation of the equilibrium regime-shifting dynamics
implied by our model. Our empirical specification successfully captures spot
and futures data. Finally, the specific empirical implementation we use is
designed to easily facilitate commodity derivative pricing that is common in
two-factor reduced form pricing models.
Friday Track II
Competition and Strategy
Chairperson: Marcel Boyer, U. Québec - Montréal, CIRANO & CIREQ
10:30 AM
Strategic Investment in Networks
Nalin Kulatilaka,
Lihui Lin,
Abstract
We examine how the presence of network effects influences investment
decisions. Building a network requires significant upfront investment but
benefits carry tremendous uncertainty. This creates an incentive to defer the
commitment of irreversible investments. However, such investments may also
create the opportunity to convince the consumers about the network's size,
establish a network standard, and preempt future competitors. Our models
account for the tradeoff between these countervailing forces to obtain the
investment rules for building networks. First, we study the investment
decision faced by a monopolist in both the investment opportunity and product
market. By investing prior to the resolution of uncertainty, the monopolist
convinces the consumers of the network size. We solve for the threshold level
of expected demand which must be exceeded in order to commit the investment.
This threshold is lowered by an increase in the intensity of the network
effect but the effect of uncertainty on the investment threshold is
ambiguous. Our second model allows for future competitor entry where the
entrant may either adopt the monopolist's standard or build its own network.
We find that the optimal licensing fee may be lower than the highest level
that the entrant would accept. When future competition is anticipated, the
investment threshold is monotonically decreasing in both the intensity of
network effects and the level of uncertainty.
10:55 AM
A
Two-stage Investment Game in Real Option Analysis
Junichi Imai, Iwate Prefectural
University (IPU)
Takahiro Watanabe, Tokyo Metropolitan U.
Abstract
This paper investigates an interaction between the managerial flexibility
and the competition. We consider a two-stage game with two firms under demand
uncertainty that follows a one-period binomial process. The cash flow
generated from a project depends on both the demand and the firms' actions.
We assume that the two firms make decisions sequentially at each stage
whether they invest in the follow-up project. One firm called a leader primally makes a decision, and the other firm called a
follower decides secondly after observing the leader's decision. Namely, a
leader has a competitive advantage over a follower. Both firms' managers can
invest at either of stages, hence they can defer
their decisions for investment at the first stage. This means that they have
flexibility to defer the project until the second stage. This flexibility can
be considered a real option to defer the project. Although the model developed
here is very simple the implication from the model is plentiful. We fully
characterize the equilibrium strategies for both firms which are classified
by their investment costs. We consider situations where either or both firms
can invest only at the first stage. By comparison among these situations, we
can analyze the effects of flexibility and competition. Our results indicate
that under a monopolistic environment the existence of flexibility has a
positive impact on the project value. However, under the competitive
environment the effects of flexibility are not straightforward. For a
follower obtaining the flexibility always increases the project value. On the
other hand, a leader could decrease a project value by obtaining the
flexibility on the condition that the follower can invest only at the first
stage. We call it flexibility trap and this result can be interpreted as
commitment effects in game theory.
11:20 AM
Third
Generation Mobile Games
Dean Paxson,
Abstract
The third generation technology will confer to mobile phones all the
capacity and speed of a fixed line phone with the additional flexibility of
mobility. Major investments in 3G installation facilities are planned in
developed economies; the reported investment plans indicate
"leader-follower" patterns.
Using three real competition options models, we determine the optimal timing of 3G investment of one Portuguese mobile company, Optimus, taken as the follower. In the first of those models both the number of units sold and the cash flow per-unit of the players follow separate but possibly correlated geometric Brownian motion. In the second model the investment cost and the operating cash flow are the state variables. The third model assumes that the investment cost and the operating cash flow stream of the total market follow separate geometric Brownian motion and that the market share of the follower occurs according to a Poisson process.
Consistent parameters are used to derive the leader and follower value functions for different models, which are compared to a traditional NPV valuation analysis. A positive NPV points to the acceptance of the investment and the immediate entry of all of the players in the market.
The results of all the models point to the delay of the entry of the follower, which might account for the observed behaviour of the actual players.
Keywords: Competitive real options, Empirical application of real options, two factor models, duopoly
11:45 AM
Real Options and Strategic
Competition
Marcel Boyer, U. de Montréal, CIRANO & CIREQ
Eric Gravel, CIRANO
Pierre Lasserre, U. Québec - Montréal
& CIRANO
Abstract
Among investment decision tools, real option theory is reaching advanced
textbook status and is rapidly gaining reputation and influence. Although
both popular writers and specialists warn against its often daunting
complexity, they also stress its unique ability to take account of future
flexibility and the importance of future moves and decisions in valuing
current investments. The real options approach emphasizes the indivisibility
and irreversibility of investments; indivisibilities often imply a limited
number of players, hence imperfect competition. Yet, while it is often
stressed that real option theory is best to analyze investments of strategic
importance -- the word 'strategic' appears repeatedly in the real-options
literature -- the bulk of that literature involves decision makers playing
against nature rather than against other players. The analysis of strategic
considerations, in a game theoretic sense, is still in its infancy and should
be high in the real-option research agenda. Our paper reviews the main
contributions, presents a unified approach and identifies the most
significant challenges.
Friday
Luncheon Address
The Price of Everything
Michael J. Brennan,
Friday Track I
Valuing Power Investments
Chairperson:
1:45
Choice of Electric Power
Investments under Uncertainty: The Value of Modularity
Christian Gollier, U. de Toulouse
David Proult, Commissariat à l'Energie Atomique
Françoise Thais, Commissariat à l'Energie Atomique
Gilles Walgenwitz, Commissariat à l'Energie Atomique
Abstract
We consider the decision making of a firm in the electricity sector facing
two alternative investment projects. The first possible outcome is an
irreversible investment in a large nuclear power plant. The second one
consists in building a flexible sequence of smaller, modular, nuclear power
plants on the same site. In other words, we compare the benefit of the large
power plant project coming from increasing returns to scale, to the follow-on
opportunities offered by the modular project to adapt the investment strategy
depending on the level of risk. We use the theory of real options to measure
the value of the sequence of decisions to invest in the successive modules,
under price uncertainty. From this theory, it is well-known that risk-neutral
entrepreneurs will decide to invest only if the market price of electricity
exceeds the cost of electricity production by a positive margin which is an
increasing function of the market risk. In particular, this margin is larger
for the irreversible investment than for the modular project. This is because
the investment process in the modular project can be interrupted at any time
when the market conditions deteriorate, thereby limiting the potential loss
of the investor. We consider in particular an environment where the discount
rate is 8% and volatility of the market price of electricity equals 20% per
year. The modular project consists in four units of 300 MWe
each, with 40% of the total overnight cost borne by the first module. We show
that the benefit of modularity is equivalent in terms of profitability to a
reduction of the cost of electricity by one-thousand of a euro per kWh.
2:10 PM
Flexibility and Technology
Choice in Gas Fired Power Plant Investments
Erkka Näsäkkälä,
Stein-Erik Fleten,
Abstract
The value of a gas fired power plant depends on the spark spread, defined
as the difference between the unit price of electricity and the cost of gas.
We model the spark spread using two-factor model, allowing mean-reversion in
short-term variations and uncertainty in the equilibrium price to which
prices revert. We analyze two types of gas plants. The first type is a base
load plant, generating electricity at all levels of spark spread. The second
type is also a base load plant from the outset, but can be upgraded, at a
cost, to a peak load plant generating electricity only when spark spread
exceeds emission costs. We compute optimal building and upgrading thresholds
for such plants when the plant types are mutually exclusive. Our results
indicate that selecting a project which is first profitable leads to a
non-optimal investment policy, and that increase in short-term volatility
preempts upgrading whereas increase in equilibrium volatility delays
upgrading.
Valuing Power Derivatives: a
Two-Factor Jump-Diffussion Approach
Pablo Villaplana, U. Pompeu
Fabra -
Abstract
We propose a two-factor jump-diffusion model with seasonality for the
valuation of electricity future contracts. The model we propose is an
extension of Schwartz and Smith (Management Science, 2000) long-term /
short-term model. One of the main contributions of the paper is the inclusion
of a jump component, with a non-constant intensity process (probability of
occurrence of jumps), in the short-term factor. We model the stochastic behaviour of the underlying (unobservable) state
variables by Affine Diffusions (AD) and Affine Jump Diffusions (AJD). We
obtain closed form formulas for the price of futures contracts using the
results by Duffie, Pan and Singleton (Econometrica, 2000). We provide empirical evidence on the
observed seasonality in risk premium, that has been
documented in the PJM market. This paper also complements the results provided
by the equilibrium model of Bessembinder and Lemmon
(Journal of Finance, 2002), and provides a simple methodology to extract
risk-neutral parameters from forward data, that may be used for calibration
of real options models. The model may also be used for scenario generation,
valuation of financial options (trough inversion of the characteristic
function) and real options applications.
Friday Track II
Competition & Games
Chairperson: Marco A. G. Dias, PUC-Rio de Janeiro & Petrobras
1:45 PM
Continuous-Time Option
Games/Review of Models and Extensions: Oligopoly and War of Attrition
Marco A. G. Dias, PUC-Rio de Janeiro & Petrobras
Jose Paulo Teixeira, PUC-Rio de
Janeiro
Abstract
This sequel paper analyzes other selected methodologies and applications
from the theory of continuous-time (real) option games - the combination of
real options and game theory. In the first paper (Dias & Teixeira, 2003), we analyzed preemption and collusion
models of duopoly under uncertainty. In this second paper we focus on models
of oligopoly under uncertainty and war of attrition under uncertainty. We
also review the literature on other option games models such as models of
positive externalities with network effects, models with either incomplete or
asymmetric information, evolutionary option games, the models limitations,
and suggestions for future research. In the oligopoly model we follow
Grenadier (2002), discussing two important methodological insights that
simplify many option games applications: the Leahy's principle of optimality
of myopic behavior and the "artificial" perfectly competitive
industry with a modified demand function. We discuss both the potential and
the limitations of these insights. Next, we extend to the continuous-time
framework the option game model presented in Dias (1997), a war of attrition
under uncertainty applied to oil exploration prospects. In this model of
positive externality the follower acts as free rider receiving additional
information revealed by the leader's drilling outcome. The way to model the
information revelation in oil exploration is another extension of the
original option game model. In this model we have three different kinds of
uncertainties, namely the market uncertainty (oil prices), technical
uncertainty (existence, quality and volume of a oil
reserve), and strategic uncertainty (incomplete information on the other
player). In addition, we analyzed the possibility of coordination by the oil
companies be perfect Nash equilibrium, changing the game depending on the
information revelation parameters. We also show that the option game premium
can be much higher than the traditional real option premium in either war of
attrition or cooperation when the latter is Nash equilibrium. This is
generally the opposite of the oligopoly under uncertainty case, when the
option game premium is lower than the traditional, is zero in the limit of
infinite firms, and can be even negative in special preemption cases.
Keywords: option games, option exercise games, real options, stochastic game theory, oligopoly under uncertainty, war of attrition under uncertainty, information revelation, incomplete information, option game premium, Leahy's optimality of myopic behavior.
2:10 PM
The Optimal Decision to Invest
in a Duopoly Market for (Two) Positioned Companies when there are Hidden
Competitors
Paulo J. Pereira, U. of Minho - Portugal
Manuel J. Armada, U. of Minho - Portugal
Abstract
The aim of this paper is to study the option to invest in a duopoly
market, allowing for more competitors to enter the market. In fact, we relax
the common assumption which states that (only) two firms compete for the two
places in the market. In the existing models, the problem consists of,
basically, defining which one will be the leader, which will be the follower,
and when. We can say that, in these settings, the investment opportunities
are semi-proprietary, since the follower's position is, at least, guaranteed
for both firms. As we said, our approach relaxes this assumption, allowing
for more than two competitors for the positions on the duopoly. This
additional competition has, as we will see, a major impact on the decision to
invest. We also allow for both ex-post symmetry and ex-post asymmetry, and for asymmetrical investment costs for the
leader and for the follower.
2:35 PM
Vulnerable Options in Supply
Chains: Effects of Supplier Competition
Volodymyr Babich,
Abstract
This paper presents valuation of inventory-reorder options in a
competitive environment with defaultable suppliers.
Analysis of a single period model of a supply chain with two suppliers, a
retailer, and exogenous sources of defaults, leads to a number of surprising
observation on the effects of the supplier credit risk and competition on the
value of the deferment option, retailer's procurement and production
decisions, suppliers' pricing decisions, and firms profits. In particular,
when wholesale prices are fixed, introduction of the deferment option may
benefit the supplier with longer production lead-time at the expense of the
supplier with shorter production lead-time and there are conditions for the
retailer's profit to be increasing in default correlation. When wholesale
prices are allowed to vary, analysis of the game between suppliers shows that
introduction of the deferment option diminishes competition between suppliers
and, thus, hurts the retailer if supplier defaults are highly correlated. On
the other hand, retailer's profit is increasing in supplier default
correlation if the level of correlation is low.
Friday Track I
Valuing Infrastructure & Network
Investments
Chairperson: Dohyun Pak,
3:30 PM
From
Access to Bypass
Keizo Mizuno, Kwansei
Gakuin U. - Japan
Keiichi Hori, Ritsumeikan U. - Japan
Abstract
This paper examines firms' incentives for irreversible investments in
network industries with a stochastically growing demand. An access-to-bypass
strategy equilibrium is characterized in terms of an access charge premium
and an incrmental profit flow accrued from access
to bypass. We then discuss some properties of the investment timings in the
equilibrium, such as the preemption effect, the role of opportunity to access
an incumbent's network facility, the effects of uncertainty and the access charge.
The feasiblity of the optimal investment timing is
also examined.
3:55 PM
A Real Option Approach to
Telecommunications Network Optimization
Dohyun Pak, U. of Michigan
Jussi Keppo,
U. of Michigan
Abstract
We optimize network flow by minimizing network blocking and/or delay and
by modeling network routing possibilities as real options. The uncertainties
in the network are driven by stochastic point-to-point demands and we
consider correlations among them in a general network structure. We derive an
analytical approximation for the blocking/delay probabilities and solve the
optimal network flows by using a global optimization technique. We illustrate
the model with examples.
4:20 PM
Building
Real Options into Physical Systems with Stochastic Mixed-Integer Programming
Richard de Neufville, MIT
Tao Wang, MIT
Abstract
The problem of building real options into physical systems has three
features:
- real options are not as easily defined as financial options;
- path-dependency and interdependencies among projects mean that the standard tools of options analysis tools are insufficient; and
- the focus is on identifying the best way to build flexibility into the design — not to value individual options.
This paper suggests a framework for exploring real options in physical systems that especially addresses these two difficulties. This framework has two stages: options identification and options analysis. The options identification stage consists of screening and simulation models that focus attention on a small subset of the possible combination of projects. The options analysis stage uses stochastic mixed-integer programming to manage the path-dependency and interdependency features. This stochastic formulation enables the analyst to include more technical details and develop explicit plans for the execution of projects according to the contingencies that arise. The paper illustrates the approach with a case study of a water resources planning problem, but the framework is generally applicable to a variety of large-scale physical systems.
Keywords: real options, stochastic mixed-integer programming, physical systems, and water resources planning
4:45 PM
Investing
in Transportation Infrastructure Under Uncertainty
Jean-Daniel Saphores, U. California -
Irvine
Marlon Boarnet, U. California -
Irvine
Abstract
We analyze the impact of uncertainty and irreversibility on the timing of
building urban transportation infrastructure. We consider a monocentric urban area where the population varies
stochastically in continuous time, which impacts land rents, land prices, and
transportation costs through congestion. A transportation agency can decide
if and when to build transportation infrastructure that reduces congestion. A
numerical application using realistic parameters illustrates the interplay
between volatility and the lower and upper bounds on the city's population.
Our results highlight the importance of accounting for the value of the
option to build infrastructure in a benefit/cost analysis.
Friday Track II
Valuation Issues & Applications
Chairperson: Sigbjørn Sødal,
3:30 PM
Valuation of Intellectual
Capital
Sudi Sudarsanam,
Cranfield U.
Ghulam Sorwar,
Cardiff U.
Bernard Marr, Cranfield U.
Abstract
Intellectual capital is an increasingy major
component of the total capital of firms as firms move from manufacturing and
industrial activitities towards services and more
knowledge-based activities. Relative to the other components of a firm's
capital such as physical and monetary capital, intellectual capital (IC)is more difficult to define, measure, manage and value in
the traditional sense. Yet given the profound importance of such assets to
firm's competiitve advantage and value creation
capabilities, serious attempts need to be, and increasingly are, made to
establish clear definitions, measurement rules and vauation
principles. In this paper we discuss intellectual capital from a valuation
perspective. We examine the nature of such capital and why traditional
valuation models fail to reflect the unique characteristics of IC. We devlop a valuation perspective based on real options
models that have been extended from their origins in financial asset
valuation to the valuation of firms' growth opportunities. Intellectual
assets embody these opportunities contributing to both their evouton over time and their realization in the future.
This approach provides a richer framework to anayse
the issues that confront the valuation of IC than traditional valuation
approaches.
Modelling Suicide Risk in Later Life
Chi-Fai Lo,
Abstract
Affective disorder is generally regarded as the prominent risk factor for
suicide in the old age population. Despite the large number of empirical
studies available in the literature, there is no attempt in modelling the dynamics of an individual? level of suicide risk theoretically yet. In particular, a
dynamic model which can simulate the time evolution of an individual? level of risk for suicide and provide quantitative
estimates of the probability of suicide risk is still lacking.
Aims and Methods: In the present study we apply the contingent claims analysis approach of credit risk modelling in the field of quantitative finance to derive a theoretical stochastic model for estimation of the probability of suicide risk in later life in terms of a signalling index of affective disorder. Our model is based upon the hypothesis that the current state of affective disorder of a patient can be represented by a signalling index and exhibits stochastic movement and that a threshold of affective disorder, which signifies the occurrence of suicide, exists.
Results and Conclusions: According to the numerical results, the implications of our model are consistent with the clinical findings. Hence, we believe that such a dynamic model will be essential to the design of effective suicide prevention strategies in the target population of older adults, especially in the primary care setting.
4:20 PM
Investment
Applications in the Shipping Industry: An Overview
Stavros Tsolakis,
Abstract
This paper introduces Real Option Analysis and exotic options in particular
as an alternative to the traditional capital budgeting technique for
4:45 PM
Market Switching Options
for Shipping Carriers
Sigbjørn Sødal,
Agder U. - Norway
Steen Koekebakker, Agder
University
Roar Aadland, Clarksons
Research & Agder U. - Norway
Abstract
The paper derives and applies a net present valuation model of
flexibility under mean-reverting prices. The model is an Ornstein-Uhlenbeck version of a standard entry-exit model as in Dixit (1989). It is applied empirically to international
shipping, valuing the option to switch between the dry bulk and wet bulk
market segments for a combination carrier, which is more expensive to buy
than conventional oil tankers and drybulk ships. A
fixed cost is incurred every time the combination carrier switches between
the segments. The estimated value of flexibility is related to historical
price differentials between combination carriers and ships with no such
flexibility. Various thresholds for when combination carriers are more
profitable are discussed, conditional on how freight rates are correlated,
the size of the switching costs, and vessel cost differences.
Friday
Keynote Address
Real Options After 27 Years
Stewart
Dr. Myers is the Gordon Y Billard Professor of
Finance at the Massachusetts Institute of Technology's Sloan School of
Management. He is past President and Director of the American Finance
Association, and co-author of the leading graduate-level textbook on
corporate finance. His research is primarily concerned with the valuation of
real and financial assets, including real options, corporate finance and
governance, and financial aspects of government regulation of business.
Professor Myers was the first to point out the existence and importance of
real options in his 1997 Journal of Finance article on the
“Determinants of Corporate Borrowing,” which spawned the growth
of this new and vibrant field. He has followed on with analysis of the
abandonment option, applications in pharmaceuticals and other areas, and
helped establish the new field through acceptance in finance textbooks.
Professor Myers is a Research Associate of the National Bureau of Economic
Research and a Principal of The Brattle Group, Inc. He is active as a
financial consultant.
Breakfast
Saturday Track I
Technology Investments
Chairperson: Pierre Lasserre, U. Québec -
Montréal & CIRANO
Quantifying the Strategic Option
Value of Technology Investments
Han Smit,
Abstract
We develop an integrated real options and industrial organization
framework to quantify the strategic option value of technology investments.
Strategic investments (e.g., R&D, capacity expansion or strategic
acquisitions) are difficult to analyze based on standard approaches. Yet, it
is these decisions that determine a firm’s competitive success in a
changing technological and competitive landscape. How much is a strategic
option (e.g., Microsoft’s growth opportunities) worth? How does one
analyze strategic options in a dynamic, competitive environment? We describe
basic principles for analyzing competitive strategies under uncertainty based
on an integration of real options with game theory. We analyze multi-stage
investment decisions facing a firm under uncertainty, both under a
proprietary setting and when facing exogenous or endogenous competition (both
in the last stage of commercialization as well as in the innovation or
R&D stage). Competitive strategies may differ, e.g., depending on the
type of investment (proprietary or shared) and the nature of competitive
reactions (strategic substitutes or complements). The benefits of cooperation
(via joint R&D ventures) vs. direct R&D competition (innovation
races) are also discussed. Finally, we analyze multiperiod
option games with endogenous volatility and discuss various other extensions.
8:55 AM
Technological Portfolio
Diversification
Ilhem Kassar, U.
Québec - Montréal
Pierre Lasserre, U. Québec - Montréal
& CIRANO
Abstract
We investigate the notion of portfolio in a real options framework; more
precisely, we study an investment problem when competing technologies are
able to achieve a specific production objective while having the potential to
generate operating options. What combination of assets should be acquired?
According to which decision rules?
A firm has the opportunity to acquire production units of a given capacity. Two technologies are available, with different risk characteristics. Besides the choice between the two competing technologies, the investor has to decide how many capacity\ units to install (growth options) with no constraints on technological uniformity or timing. Thus the firm may decide to hold zero units, one unit of either type, two units of one type, two units of the alternative type, one unit of each type, etc. We limit the analysis to two units, but the methodology can be extended to many units.
Changes in the production scale of any unit of capacity are costless; this
gives a technologically diversified firm a certain operating flexibility to
adjust to fluctuations in production costs. This operating flexibility is
similar to a switch option, but differs in three important ways: first any
combination of production between two units is possible, subject to the
capacity of each unit; second, for the owner of two different units, taking
advantage of operating flexibility involves letting the (currently) least
efficient unit sit totally or partially idle; finally, the operating flexibility
option may be acquired as a one shot purchase of two capacity units, or as a
decision to extend capacity by choosing a different technology at the second
acquisition. This apparently benign feature in the acquisition of a
technology portfolio that, ex post, may be considered a flexible
package, turns out to make an important difference in the acquisition process
and the ex ante
In the model described above, with its multiple underlying options, we
analyze the operational and investment decision processes and show how and
under which conditions portfolio optimization leads to a technologically
diversified, or a specialized, portfolio. The analysis emphasizes that
project
Key words: Real options; Portfolio; Flexibility; History.
J.E.L. classification: C610, D92; G11, G12.
9:20 AM
Irreversible Investment in
Alternative Projects
Jean-Paul Décamps, U. de Toulouse
Thomas Mariotti , U. de Toulouse
&
Stéphane Villeneuve,
U. de Toulouse
Abstract
We examine the problem of a risk-neutral investor who has to choose among
two alternative projects of different scales under output price uncertainty.
We show that as soon as investment in the smaller scale project is sometimes
optimal, the optimal investment strategy is not a trigger strategy and the
optimal investment region is dichotomous. Whenever the investor has the
opportunity to switch from the smaller scale to the larger scale project, the
dichotomy of the investment region can persist even when uncertainty becomes
large.
Optimal
Scrapping and Technology Adoption under Uncertainty
Hervé Roche, ITAM
Abstract
A firm has to decide sequentially to replace its technology and to
implement a new one chosen among an increasing range over time under
technological and market uncertainty. The optimal decision rule is a (s,S) style policy where the trigger
and target technology levels are positively correlated with boom persistence
and negatively related with recession persistence and technological
uncertainty. The average time between two adoptions is governed by several
factors. Bounded technological progress imposes a limitation on the best
grade available, which can accelerate updating when the firm wishes to
continue to operate an advanced technology. Technological uncertainty
reinforces depreciation and thus hastens replacement. Moreover, both types of
uncertainty have an impact on the scrapping and upgrading levels. Overall,
adoption is more frequent for economies spending a large fraction of time in
booms. The likelihood of switching during a recession is negatively affected
by the arrival rate of booms. The end of a recession can trigger updating
since the firm will want to operate an efficient technology in order to seize
the high cash flows associated with the forthcoming boom. This result implies
that investment spikes are procyclical.
JEL Classification: D81, D92, O33 Keywords: Technological Uncertainty, Market Uncertainty, Optimal Timing, Innovation Adoption, Option Value
Saturday Track II
Theoretical Issues
Chairperson: Vicky Henderson,
8:30 AM
Smooth Pasting as Rate of Return Equalisation
Sigbjørn Sødal,
Mark Shackleton,
Abstract
In this short note we elucidate the smooth pasting condition that is
behind the optimal early exercise condition of options. It is almost trivial
to show that smooth pasting implies rate of return equalisation
between the option and the levered position that results from exercise. This
yields new economic insights into the optimal early exercise condition that
the option holder faces.
Valuing
Options to Learn: Optimal Timing of Information Acquisition
Pauli Murto,
Abstract
This article considers the value of information and optimal timing to
acquire it in a model of irreversible investment. There are two types of
uncertainties: the value of the investment project depends on
1) an observable stochastic process and
2) an ex-ante uncertain parameter, whose true value may be learnt at a cost.
The former type of uncertainty implies that the opportunity to acquire
information has an option-like character. We derive and characterize the
value of such learning options and the optimal timing to learn.
9:20 AM
Real Options Valuation within
Information Uncertainty
Mondher Bellalah, U. de Cergy, France
Abstract
This paper develops some results regarding the economic value added and real
options. We use Merton’s (1987) model of capital market equilibrium
with incomplete information to introduce information costs in the pricing of
real assets. This model allows a new definition of the cost of capital in the
presence of information uncertainty. Using the methodology in Bellalah (2001,
2002) for the pricing of real options, we extend the standard models to
account for shadow costs of incomplete information.
Keywords : EVA, real options, information costs
JEL Classification : G12, G20, G31
Valuing Real Options without a
Perfect Spanning Asset
Vicky Henderson,
Abstract
The real options approach to corporate investment decision making
recognizes a firm can can delay an investment
decision and wait for more information concerning project cashflows.
The classic models of McDonald and Siegel (1986) and Dixit
and Pindyck (1994) value the investment decision as
a perpetual American option and in doing so,
essentially assume the real asset underlying the option is traded, or that
there is a perfect spanning asset available. Our model relaxes this
assumption and assumes only a partial spanning asset can be found. In this
model, we obtain in closed form the value of the option to invest and the
optimal investment trigger level, above which investment takes place. These
both depend additionally on the correlation between project cashflows and the spanning asset, risk aversion of the
firm's shareholders, and volatilities of project cashflows
and the spanning asset. The value of the option to invest and the trigger
level are both lowered when the spanning asset is less than perfect. Although
the partial spanning model contains the classic model as a special case, it
is much richer. In particular, there are parameter combinations where the
classic model recommends the firm never invests, whereas if a highly (but not
perfectly) correlated spanning asset were assumed, the firm should invest at
a certain trigger level.
Saturday Track I
Agency Issues
Chairperson: Bart Lambrecht,
10:30 AM
The
Option to Change One Construction Contract for Another
Said
Abstract
This article explores a new field of application for real options. That
is to resolve the principal-agent problem arising in procurement contracts.
The impossibility of writing complete and enforceable contracts gives the
contractor the opportunity of earning by cheating. The best way of dealing
with the problem is to design a contractual mechanism that would stop a
self-interested contractor from taking benefit that would result from a postcontractual opportunism. This mechanism can be based
upon conclusion of two types of contracts with an option that provides the
owner the exclusive right of choosing at the expiration date which contract
to apply. This mechanism looks like an option to change one contract for
another. The fixed price contracts includes an
option on cost-reimbursement contracts and vice versa. By this mechanism, the
contractor will not be willing to behave to the detriment of the owner
because the latter can exercise the option and the contractor will become the
victim of its own actions.
10:55 AM
Concession
Agreements in the Shipping Industry
Carmen Juan,
Fernando Olmos,
Juan Carlos Perez,
Abstract
In this paper we present a methodology for designing concession
agreements in the shipping industry. Such methodology allows us making
return-risk stochastic analysis of both parts of the concession agreement,
quantifying the value of the risk transfers that underlie concessions, and
finally valuing those sweeteners included in agreements that require a real
options approach. We make use of standard stochastic return-risk analysis,
joint with an specifically designed numerical
algorithm for the sweeteners valuation. The implementation of the whole
methodology has been done in Excel and is based on a broad empirical study of
the expansion of
A Theory of Takeovers and
Disinvestment
Bart Lambrecht,
Stewart Myers,
Abstract
We present a real-options model of takeovers and disinvestment in
declining industries. As product demand declines, a first-best abandonment
level is reached, where overall value is maximized by shutting down the firm
and releasing its capital to investors. Absent takeovers, managers of
unlevered firms always abandon the firm’s business too late. We model
the managers’ payout policy absent takeovers and consider the effects
of leverage on managers’ shut-down decisions. We analyze the effects of
takeovers of unleveraged or under-leveraged firms.
Takeovers by raiders enforce first-best abandonment. Hostile takeovers by
other firms occur either at the first-best abandonment point or too early. We
also consider management buyouts and mergers of equals and show that in both
cases closure happens inefficiently late.
JEL Nos.: G34, C72, G13.
Keywords: disinvestment, takeover, real option, managerial incentives,
payout, debt
Saturday Track II
Computational Issues &
Approaches
Chairperson:
10:30 AM
Estimation of Volatility
of Cross Sectional Data: A Kalman Filter Approach
Cristina Sommacampagna,
Abstract
In order to perform a Real Option
Keywords: Real Options; Cross-Sectional Data; Kalman Filter.
10:55 AM
Market and Process Uncertainty
in Operations
Keith Ord,
Abstract
By adopting a real options framework, we develop and analyze a production
control model that jointly incorporates process and market risks. In our model,
process risk is typified by random yield variability while market risk is
defined through demand uncertainty. The stochastic processes used to depict
uncertainty in these state variables reflect a wide variety of distributional
forms and are not confined to the traditional processes typically used in the
real options literature. In our approach, the production inputs represent
renewable, partially renewable or non-renewable resources. Furthermore, the
production outputs are treated as non-traded assets, so that the model has a
much broader range of applicability beyond that of standard commodities for
which futures contracts trade. Given this setting, techniques of contingent
claims analysis and stochastic control theory are employed to obtain value maximizing
production policies in a constrained capacity environment. In light of the
stochastic nature of the state variables, the rate of production is modeled
as an adapted positive real-valued process and analogously
Valuing
the Surrender Options Embedded in a Portfolio of Italian Life Guaranteed
Participating Policies
Giulia Andreatta,
RAS Spa -
Stefano Corradin, U.
Abstract
We price the surrender option embedded in two common types of guaranteed
participating Italian life contracts and we adopt the Least Squares Monte
Carlo approach following Longstaff and Schwartz
(2001) giving a comparative analysis with the results obtained through a
Recursive Tree Binomial approach according to Bacinello
(2003). We present an application to a major Italian life policies portfolio
at two different market valuation dates. We use a Black & Scholes-CIR++ economy to simulate the reference fund; we
estimate the fair value of portfolio's liabilities according to De Felice and Moriconi (2001),
(2002) and Pacati (2000); extending the framework
to price the embedded surrender options.
Saturday
Panel Discussion
Moderator:
Marcel Boyer, U. Québec - Montréal,
CIRANO & CIREQ
Michael Brennan, UCLA
Bart Lambrecht, Lancaster U.
Stewart
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