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Annual International Conference on Real Options: Theory Meets Practice

10th Annual International Conference

New York City USA, June 14-17, 2006

Abstracts and Links to Papers

Thursday | Friday | Saturday

 We post updated versions of papers as they are sent to us and change the file name to be the same as the older version. If you want to conveniently download all the papers and make sure you have the latest versions, go to the Apache listing of the folder containing the papers, which is sorted by date here.




9.30 - 10.45 Empirical Evidence I

Optional Value of IS Projects: An In-depth Study at a Multinational Manufacturer
Jim Kenneally, University College Dublin, Ireland
Yossi Lichtenstein, University College Dublin, Ireland

The IS research literature has tested the applicability of option pricing models to IS projects mostly through detailed case studies. The current study complements this literature by considering a wide set of IS projects and assessing, albeit crudely, their optional value. We test the literature’s assumption that IS projects embed significant optional value. Our research site is a European plant of a leading multinational manufacturer of sophisticated products. The portfolio of current and recent IS projects is studied through a questionnaire administered to all project managers. Seventeen project managers were interviewed concerning thirty-one projects with median cost of $325k and median benefit of $1.2m. We find strong support to the prediction that IS projects include considerable optional value. The thirty one projects we studied embed forty seven options, many of them with benefits comparable to the value of the original projects. Only four projects had no optional value. A comparison between a subset of the portfolio and the corresponding scale-up options shows that the exercise price of the options is 20% of the original projects’ cost, and that the value of these options is about 70% of the original projects’ value. This data also demonstrates the large return, of scale-up options – the median return is 1500%, five fold the median return of projects. The main practical implication of this study is that real option evaluation is useful for IS projects in general, and should not be confined to special cases. A further implication is that real option thinking may be of particular value in recognising reduction and deferral options. The project managers in our study found such options difficult to identify and considered their time to expiration as relatively short. Proactive management of reduction and deferral options should thus increase the flexibility and value of IS projects.

Real Options in Firm Valuation: Empirical Evidence from European Biotech Firms
Gracia Rubio, Madrid Europa University, Spain
Prosper Lamoth, Madrid Autonoma University, Spain

Firms’ intangible assets are becoming more and more relevant in the different areas within the financial discipline. Its management, its quantification and its valuation nowadays constitute one of the main challenges which economy and business try to face. Through this paper we will evaluate some models based on the real options theory in order to estimate the intangible assets value of certain firms, specifically I+D biotechnological firms projects. With this aim, and after deep research on biotechnological industry, we will establish the parameters regarding one model which can be considered as a quantitative valuation method that we apply to a sample of biotechnological European companies. The results obtained through the empirical analysis are promising and they support the use of the real options theory to evaluate biotechnological firms.

Multinationality and Real Options: Empirical Evidence
Tarik Driouchi, Aston Business School, UK
Giuliana Battisti, Aston Business School, UK
David Bennet, Aston Business School, UK

This paper studies the relationship between multinationality and performance under a real options lens. Based on a cross-sectional panel of multinational corporations (MNCs) that are likely to use real options reasoning for the management of their operations, we test the impact of operating and strategic options on firms’ risk-returns parameters. Our evidence reveals that both multinationality and flexibility enhance corporate performance and reduce downside risk.


11.15 - 12.30 Venture Management

Stage Financing, VC Short-termism and Managerial Replacement
Dima Leshchinskii, Rensselaer Polytechnic Institute, USA
Neil Brisley, University of Western Ontario, Canada

This paper studies how the information available from potential investors determines an entrepreneur's choice of financing. In our two-period model, which allows stage financing, the entrepreneur chooses financing for his own new project from pool of potential investors. The pool includes business angels, venture capitalists and traditional atomistic investors. The entrepreneur's choice of financing depends on the additional value to the project brought by the investors' abilities to resolve over time the uncertainties about the project and by the actions they can take, such as replacing the manager or cutting the investment. We obtain explicit analytic solutions for the choice of investor and for the amount of investment at each stage. Our results show that the entrepreneur chooses angel or venture capital financing when the intertemporal resolution of uncertainty creates value which exceeds the associated cost. The venture capitalist emerges as the preferred investor when potential manager replacement is an ex-ante valuable option. These results are consistent with observed market practice.

Real Options and Termination Clauses in Joint Ventures and Strategic Alliances
Carmen Juan, University of Valencia, Spain
Fernando Olmos, University of Valencia, Spain
Rahim Ashkeboussi, Frostburg State University, USA

This research focuses on valuation models of restatement of ownership clauses and termination clauses in joint ventures and strategic alliances. Due to the special nature of this type of agreements, a methodological approach has been developed to capture the underlying market as well as strategic risk of these types of clauses. As these clauses become operative if certain events (triggers) occur, this study develops valuation models that take into account the contingent nature of these clauses. Based on recent joint ventures and strategic alliances, this study presents valuation models and algorithms as tools for designing and negotiating agreements between parties. However, the scope of this research is beyond this limited objective. The special nature of option models proposed in this study provides a new approach for evaluating a variety of strategic decisions.

An Option-Based View of Imperfect Patent Protection
Philipp Baecker, European Business School, Germany

Given a noticeable degradation of patent quality, patenting has come to resemble the purchase of a lottery ticket. Rising cost of engaging in litigation over intellectual property (IP) assets substantially diminishes their value as an incentive to invest in research (Lanjouw and Schankerman, 2001). The author proposes an option-based view (OBV) of imperfect patent protection as a formal strategic model of so-called probabilistic patents (Lemley and Shapiro, 2005), which may serve as a starting point for further investigations into the impact of patent risk on firm values and research incentives. More specifically, the real option approach is employed to demonstrate how, due to increased litigation activity in red oceans, rising profit rates may lead to falling patent values, calling for a careful tradeoff between reliable patent protection in mature markets and seemingly attractive business opportunities in industries such as pharmaceutical biotechnology.


1.30 - 3.10 Empirical Evidence II


A Test of Real Options Logic by Entrepreneurs
Bernadette Power, University College Cork, Ireland
Gavin C. Reid, University of St. Andrews, Scotland

The main hypothesis examines whether real options logic is applied by entrepreneurs in undertaking key organisational change (e.g. ownership, technology, location, line of business etc.). This is explored in a model of firm performance using data collected in face-to-face interviews with entrepreneurs on the level and timing of precipitating influences of organisational change and the level and timing of consequential adjustments following organisational change. Two econometric estimation techniques (e.g. Box-Cox regression with WLS correction and Heckman sample selectivity correction) were employed. Firm performance is explained in terms of a count of real options exercised, measures of the level and timing of precipitators and consequential adjustments, plus interactions between these measures to capture firm behaviour through a real options lens. Evidence was found of the value of holding real options until uncertainties are resolved. At this point the value of waiting is at its lowest.

Valuing Corporate Announcement Options: Theory and Evidence
Anna Dempster , Birkbeck College, University of London, UK

This paper introduces a theory of corporate announcements based on the new concept of an announcement option which has not been previously recognized in the literature as an independently valuable real option de-coupled from strategy implementation. While contributing to the strategy and real options literature, the paper also bridges the corporate disclosure literature and theories of signalling. By conceptualising corporate announcements as real options, the paper provides a framework and focuses on a methodology for precisely valuing announcements. To illustrate the use and valuation of announcement options, the historical case of Prudential plc’s announcements concerning its internet venture Egg is analysed.

The Microeconomic Firm under Uncertainty: Theoretical Development and Empirical Tests
Ren Raw Chen, Rutgers University, USA
Michael S. Long , Rutgers University, USA
Xiaoli Wang, Rutgers University, USA

Our paper models and empirically tests the model of firms operating under uncertainty. The study compares firms operating in perfect competition with those producing with product market power. Our model finds that they both produce less under uncertainty from the cost of risk. In addition, our model predicts that companies with market power have a greater market value, face more product market uncertainty, use less leverage but have a similar default risk to firms in perfect competition risk. We then empirically test our model using manufacturing firms that operate in close to perfect market competition having little product differentiation and operating in low concentrated industries versus those that have product market power using advertising and/or R&D and operating in highly concentrated industries. The empirical evidence supports our hypotheses. Our study includes the “option against value” that occurs from real product market changes greatly reducing or even eliminating firms’ product markets. Using default probability estimates based on Merton’s Equity Option Pricing as the probability of an “option against value” occurring, we find smaller companies, those companies with less capital intensity and finally companies in perfect competition more likely to experience this product market shift.

Strategic Behavior, Product Market Competition and Asset Returns
Felipe Aguerrevere, University of Alberta, Canada

The effects of strategic behavior on asset returns are studied in a model of incremental investment with operating flexibility. We show how the interaction of competition and production and investment decisions influences the relation between industry structure and expected rates of return. The effect of competition on asset returns depends on the level of demand for the industry output. When demand is low firms in less concentrated industries earn higher returns. As demand increases and growth options become more valuable firms in more concentrated industries earn higher returns. We compare the predictions of our model with recent empirical evidence on industry structure and average rates of return by Hou and Robinson (2005).


3.45 - 5.00 Innovation and Technology Adoption


Technology Adoption under Uncertain Innovation Progress
Hervé Roche, Instituto Tecnologico Autonomo de Mexico, Mexico

A firm has to decide when to scrap its technology and adopt a new one chosen among a possibly increasing range over time when technological process is uncertain. Under constant return to scale, optimally the firm implements the best invented technology that may not be the latest. The gap between the operated technology and the newly implemented one has to large enough with respect to gap between the latest and state of the art technologies in order to trigger replacement. This result shows that the higher the threat a better technology may be released, the more reluctant is the firm to replace its technology. Effects of the means and the variance of technological progress on the adoption policy and frequency of upgrades are also examined. JEL Classification: D81, D92, O33 Keywords: Technological Uncertainty, Optimal Timing, Innovation Adoption, Option Value.

Dynamic Project Selection: Incremental vs. Radical Innovation under Uncertainty
Tao Yao, Penn State University, USA

Selecting between investing on R&D in incremental innovations and radical innovations is particularly challenging. In this paper, we focus on the problem of project selection under technical uncertainty and market uncertainty. After motivating the challenges and decisions facing firms using a real-life application from GM, we formulate a mathematical model of a firm that must develop its products in the presence of uncertainty. Specifically, the firm faces two options: (i) an incremental innovation project that is known to be relatively easy to develop and (ii) a radical innovation project that offers superior performance but whose development is much more difficult. We examine how characteristics of R&D projects such as projects’ relative efficiencies and future benefits affect R&D investment policy, valuation and risk premia. Our analysis helps understand the appropriateness of the different development approaches. We illustrate our model with a Hybrid Electric Cars vs Hydrogen Fuel Cell Vehicles example as pursued by GM and note the managerial implications of our analysis. Keywords: Real Options, R&D Projects, Stochastic Differential Equation, Managerial Flexibility, Project Management.

Real Options as a Source of ICT Network Investment under Technological Advance
Russel Cooper, University of Western Sydney, Australia
Gary Madden, Curtin University of Technology, Australia

This paper constructs a model of ICT network investment behavior by a typical firm engaged in productive activity for which ICT serves as a GPT. The firm has options to enter into activity facilitated by technological advance. Investment is decomposed in a manner analogous to growth accounting. The approach identifies factors that influence optimal investment decision making as: profitable production; optimal portfolio choice; strategic merger and acquisition; shareholder satiation; and futures preparation. The model can identify technology / preference parameters, business environment and potential government policy levers. Interaction among factors may lead to complex and possibly undesirable outcomes. In the simulation experiment parameters and functional forms are specified for the production and utility functions. These provide a grid of possibilities under which optimal choices of the control variables determined. Results are computed under a range of outcomes for the model stochastic processes. The experiments categorize optimal ICT network investment behaviour into components and shed light on the ability of this rational model to generate complex cyclical investment activity.




8.30 - 9.45
I. Conceptual Issues


Extended Binomial Tree Valuation when the Underlying Asset Distribution is Shifted Lognormal (with Higher Moments)
Tero Haahtela, Helsinki University of Technology, Finland

This paper describes a real options valuation method for situations where the underlying asset may have negative values and the underlying project present value distribution is something of the shape between normal and lognormal distribution causing skewness and kurtosis to the rate of return distribution. The underlying project value is assumed to follow a dynamic path having up and down movements with properties of both additive and multiplicative processes. This is described as a shifted lognormal process. A binomial tree solution, which is an extension to the common binomial tree models, is presented with an illustrative case example. The underlying assumptions about applying the valuation model follow the lines of consolidated volatility approach and marketed asset disclaimer.

Alternative Monte Carlo Simulation Models and the Growth Option with Jumps
Susana Alonso Bonis, University of Villadolid, Spain
Valentin Azofra Palenzuela, University of Villadolid, Spain
Gabriel De La Fuente Herrero, University of Villadolid, Spain

Recent research has revealed the usefulness of Monte Carlo simulation for valuing complex American options which depend on non-conventional stochastic processes. This paper analyses the possibilities to improve flexibility of traditional real options models by the use of simulation. We combine simulation and dynamic programming for valuing American real options contingent on the value of a state variable which evolves according to a mixed Brownian-Poisson process. We estimate the optimal exercise strategy using two alternative models, which are based on algorithms developed for financial derivatives. We evaluate both valuation proposals using a simple numerical example. The results highlight the need to achieve a trade-off between the accuracy of the estimations and the computational effort needed for this type of proposal. They also reveal the existence of non-monotonous and occasionally counterintuitive relations between the value of the growth option and the volatility and frequency of discontinuous jumps, which should be explained by the characteristics of the stochastic process under consideration.

Real Options Theory for Real Asset Portfolios: the Oil Exploration Case
Marco Antonio Guimaraes Dias, Petrobras and PUC-Rio, Brazil

This paper discusses a portfolio theory for real assets with main focus on petroleum exploration and development assets. Exploratory assets are prospects with chances to find out development assets (oilfields in this case). By the real options point of view, exploratory assets are compound options.
In opposition to financial assets portfolio theory, the paper shows that positive correlation between exploratory assets is a desirable feature because both it increases the learning option value and leverages the synergy gain with development assets. In the first case due to the sequential nature of learning with the ability to limit losses in case of bad news. In the second case because a higher (positive) correlation increases the probability of multiple success and so the synergy gain by sharing the development infrastructure.
The analysis of the simplest portfolio, i.e., with only two exploratory assets, provides important insights about learning, synergy and option to defer exploration. The optimal intertemporal distribution of projects shall use the concept of option to defer. A necessary condition for the immediate exercise of an exploratory option (wildcat drilling investment) is the existence of at least one scenario where the development option is deep-in-the-money. For all projects which deferring is optimal, we need to have an idea of both the probability of later exercise and the expected time of exercise, conditional to option exercise occurrence. This portfolio planning is necessary for resource management purposes and is performed by real-world (and not risk-neutral) stochastic processes simulation.
A multiple asset portfolio of exploratory prospects example is analyzed, highlighting the learning processes modeled as information revelation processes, with discussion of their properties.


II. Natural Resource Management/Optimal Stopping


Stochastic Forest Growth with Harvesting and Recovery Decisions
Mark Shackleton, Lancaster University, UK
Sigbjorn Sodal, Agder University, Norway

A stochastic forest rotation model in the Faustmann tradition is presented and exemplified. The model combines harvesting decisions with options to recover or clean up to restore the land after very unfavorable evolutions of the stochastic growth process. Uncertainty is shown to have a generally ambiguous effect on the optimal choice of investment strategy. It is also shown how such models can be related to theory of optimal inventory control.

Dynamic Acquisition of Investment Information and Learning under Uncertainty
Toni Nordlund, University of Helsinki, Finland

This paper studies the optimal acquisition of incremental information on an irreversible investment opportunity that is subject to economic uncertainty through a random payoff shock. Imperfect information is introduced by assuming that the payoff and the investment cost are affected by distinct multiplicative signals that at the outset are unobservable to the investor. The problem of the investor then is to decide when, if at all, to acquire the signals given that the alternative is to invest with the prior estimates. The incurred costs being completely sunk, going ahead with an acquisition translates to exercising an irreversible real option, a learning option. We show that the optimal acquisition (learning) policies are represented by two simple stopping times for the payoff shock. The policies balance the trade-off between the acquisition costs and the fact that postponing an acquisition increases the risk of learning information that would have been more beneficial when incorporated into decision making earlier. In particular, postponing increases the risk of forfeiting the optimal perfect-information investment.

Optimal Stopping Under Uncertainty
Graham Davis, Colorado School of Mines, USA
Robert Cairns, McGill University, Canada

In investment problems under certainty it is optimal to stop the program such that net present value is maximized. An equivalent, r-percent stopping rule suggests that the program should be stopped when the project’s rate of appreciation falls to the force of interest. We extend the r-percent stopping rule to the case of uncertainty, in which the program is again stopped once the project’s rate of appreciation falls (in an expectations sense) to an adjusted force of interest. This rule has all of the intuition of the rule under certainty, and the adjustment to the force of interest reveals additional insights.


10.20 - 12.00
I. Public Sector and Policy Applications


Assessing the Economic and Ecological Impacts of Agricultural Innovation under Uncertainty: The Case of GM Corn in France
Sara Scatasta, Center for European Economic Research/ Mannheim, Germany
Justus Wesseler, Wageningen University, Netherlands

In this study we introduce the concept of maximum tolerable irreversible social costs (MISTICs) as an indicator of potential welfare impacts of introducing an agricultural innovative technology. The MISTICs identify an upper bound for irreversible social costs beyond which, it would not be socially optimal to postpone the introduction of a new technology. The MISTICs including private as well as social costs and benefits, supports decision making processes that need to consider economic as well as social and environmental factors, offering a broader perspective on potential impacts of introducing technological innovations with unknown irreversible social costs. The MISTICs were computed for the case of introducing genetically modified (GM) corn in France.

Investing in Sustainable Transport Infrastructure under Investment Cost and Population Growth Uncertainty
Linda Salahaldin, Université Paris - Dauphine, France
Thierry Granger, Université Paris - Dauphine, France

In this paper, we study the problem of investing in sustainable transport to relieve air pollution under both population-growth and investment cost uncertainties. In such a case, the growth of the city population increases the demand for a sustainable transport by increasing pollution, and, in the same time, the investment cost is decreasing stochastically with time. This corresponds to a hydrogen fuel infrastructure construction, whose construction cost is continuously decreasing due to the worldwide R&D effort. Using the real options method, we show how to maximize inter-generational utility by choosing the optimal time to invest. We make use of a dynamic programming approach to calculate the expected waiting time until investing. Our numerical results show that we must wait a longer time before investing when the uncertainty is high

Price Cap Regulation and Incentives to Invest in New Capacity in Electricity Markets
Nicos Savva, University of Cambridge, UK
Fabien Roques, University of Cambridge, UK

We study the effect of price cap regulation on investment in new capacity in an oligopolistic (Cournot) industry. We use a continuous time model with stochastic demand. The contribution of this paper is both theoretical and practical. On the theoretical side, we show that there exists an optimal price cap that maximizes investment incentives. Just as in the case of deterministic demand, the optimal price cap is independent of market concentration. However, unlike the deterministic case, we show that this price cap does not restore the competitive equilibrium; there is still under-investment and companies are still enjoying positive rents. On the practical side, we perform sensitivity analysis, comparative statics and monte carlo simulations to examine the effect of price cap regulation at different levels of demand volatility, market concentration and lead times. The findings demonstrate that price cap regulation is ineffective in increasing investment in volatile markets, with high concentration and significant lead times. This casts doubts to whether price cap regulation can be effective in mitigating market power in liberalized electricity markets.

Volatility of GDP, Macro Applications and Policy Implications of Real Options
Jose Pablo Dapena,,Universidad del Cema, Argentina

The traditional marshallian rule of investing (abandoning) when the value of an underlying asset is above (below) the cost of an alternative investment is modified in the presence of uncertainty and irreversibility giving rise to an option component into decisions. This component is affected by the degree of volatility of underlying assets, which in turn can derive their volatility from the economy as a whole, affecting the investment process and therefore the accumulation of capital and future growth. In the same tense, the evidence of volatility in the returns of the underlying assets of the economy affects the market value of debt contracts, conveying recommendations regarding the financial architecture of the economy and the type of financial instruments better suited. The paper explores the application of contingent claims analysis both to the potential effect of macro volatility on aggregate investment, and to the effect on the presence of high levels of indebtedness of the economy, with a special application to the Argentinean economy where we obtain that economies with high level of volatility would require a significant level of internal saving and capital markets driven mainly by equity instruments of financing, which helps to better accommodate uncertainty by means of the price of assets.


II. Power Plant/Energy Valuation


Volumetric Risks and Valuation of A Power Plant
James He, University of Twente, Netherlands

In addition to the price risk, volumetric risks in electricity market play a second important role. We discuss the various types of volumetric risks which are related to specific constraints of power plant operation, and asses their impacts on the valuation of a power plant. The results of Monte Carlo simulations on spark spread options indicate that considering these risk factors decreases the value of a power plant. The decreasing effects of some risk factors, such as outages, maintenance and spinning reserve, are significant. The impact from the demand-side risk is not significant in magnitude, but it always jointly works with price risks. The multiplying effect makes the demand-side risk unignorable. A predetermined forward charge price on customer load cannot mitigate the demand-side risk properly.

Valuation of a Power Plant under Production Constraints
Arnaud Porchet , Ensae-Crest & Edf, France
Nizar Touzi, Imperial College, UK & Ensae-Crest, France
Xavier Warin, Edf, France

Real option models for valuating power plants are often criticised for not taking into account important features of these physical assets such as switching costs, minimum on-off times, ramp rates or non-constant heat rates. Incompleteness of electricity markets is also an important issue while valuating these kind of options. We study the valuation problem of a power plant in a continuous time commodity market, in the presence of frictions (production constraints and incompleteness of the market). We use the utility indifference approach to define the price of the associated real option. We provide a characterization by means of a coupled system of reflected backward stochastic differential equations. We derive the variational inequalities associated to the reflected BSDE system. In the absence of friction, we show that this utility-based value reduces to the classical no-arbitrage valuation. We finally give a numerical scheme for both the BSDE and the PDE and compute the value of a coal power plant.

Valuation of Stochastic Power Storage Systems
Sydney Howell, Manchester Business School, UK
Peter Duck, University of Mancheste, UK
Helena Pinto , University of Strathclyde, UK
Goran Strbac , Imperial College, UK

Wind-generated electricity supply contains significant stochastic fluctuations, which may be “smoothed” by electricity storage systems. The economic value of such storage can be calculated using real-options methods, in which we model the storage system as a perpetual, dividend-paying Asian option. In contrast to standard option models, in which the price is a stochastic variable but the physical quantity of the underlying asset is one unit, our initial model assumes that the price of electricity is one unit, and the physical flow rate of the underlying variable, wind-generated electricity, is stochastic. The valuation can be tackled by two methods: the first is a fully numerical (Monte Carlo) simulation, which involves explicit treatment of the stochastic fluctuations of three variables in time; the second is a PDE (partial differential equation) approach, in which fluctuations in the time domain need not be explicitly treated. The PDE approach requires the use of non-standard numerical methods, involving the treatment of diffusion in two opposing directions in different regions of parameter space. The agreement between the two distinct methods is excellent, although the PDE approach is considerably more efficient. The methodology (based on the PDE approach) has strong potential for developing a useful tool in valuing numerous and diverse storage systems (both physical and financial), and such possible directions are detailed in the paper.

Valuation of Natural Gas Power Plant Investment
Luis M. Abadie, BBK, Spain
Jose M. Chamorro, University of the Basque Country, Spain

This paper deals with the valuation of energy assets related to natural gas. In particular, we evaluate a baseload Natural Gas Combined Cycle (NGCC) power plant and an ancillary instalation, namely a Liquefied Natural Gas (LNG) facility, in a realistic setting; specifically, these investments enjoy a long useful life but require some non-negligible time to build. Then we focus on the valuation of several investment options again in a realistic setting. These include the option to invest in the power plant when there is uncertainty concerning the initial outlay, or the option's time to maturity, or the cost of CO2; emission permits, or when there is a chance to double the plant size in the future. Our model comprises three sources of risk. We consider uncertain gas prices with regard to both the current level and the long-run equilibrium level; the current electricity price is also uncertain. They all are assumed to show mean reversion. The two-factor model for natural gas price is calibrated using data from NYMEX NG futures contracts. Also, we calibrate the one-factor model for electricity price using data from the Spanish wholesale electricity market. Then we use the estimated parameter values alongside actual physical parameters from a case study to value natural gas plants. Finally, the calibrated parameters are also used in a Monte Carlo simulation framework to evaluate several American-type options to invest in these energy assets. We accomplish this by following the least squares MC approach.


1.45 - 3.00
I. Transportation Investing

Optimal Timing for the Construction of an International Airport: An Application at Lisbon Airport
Paulo Pereira, University of Minho, Portugal
Artur Rodrigues, University of Minho, Portugal
Manuel J Rocha Armada, University of Minho, Portugal

In this paper we study the option to invest in a new international airport, considering that the benefits of the investment behave stochastically. In particular, the number of passengers, and the cash flow per passenger are both assumed to be random. Additionally, positive and negative shocks are also incorporated, which seems to be realistic for this type of projects. Accordingly, we propose a new real options model which combines two stochastic factors with positive and negative shocks. While the authors developed this model having as reference the project for the new airport in Lisbon, the model can be applied to other airports investments, and, eventually with minimal adaptations, it can also be applied to projects in different areas.

Market Efficiency and Switching Assets in Shipping under Freight Rate Uncertainty
Sigbjorn Sodal, Agder University, Norway
Steen Koekebakker, Agder University, Norway
Roar Adland, Norwegian School of Economics and Business

The paper uses a real options valuation model with stochastic freight rates to investigate market efficiency and the economics of switching between the dry bulk and the tanker markets in international shipping. A dry bulk carrier is replaced with a tanker when the expected net present value of such a switch is optimal from a real options based decision rule. Depending on the development of the markets a reversal may take place later. The cost and demand parameters upon which the decisions to switch are made, including the stochastic characteristics of freight rates, are estimated from an empirical analysis that is updated every week throughout a 12-year time period from 1993 to 2005. The second-hand market for bulk ships seems to have been efficient most of these years in the sense that market switching usually did not pay off, with one major exception: it seemed profitable in expectation to leave the dry bulk market and enter the tanker market over a significant period of time shortly after the millennium shift, and to return to dry bulk market about three years later. These points in time corresponded with an unprecedented boom period in the tanker and drybulk freight markets, respectively, and the result suggest that agents in the second-hand market were slow to adjust their expectations. In retrospect, such an investment policy also happened to be profitable compared to staying put in the tanker market, even after accounting for transaction costs.

Investment Timing, Dynamic Operation and Flexible Contract in Transportation Infrastructure
Daniel Danau, Laboratoire d'Economie des Transports, France

In this paper, we characterize the optimal contract for investing in transportation infrastructure and providing the associated service in the presence of stochastic preferences. The relevant decision variables are the timing of investment and the supply path (in the limit of the installed capacity). Both variables depend on market dynamics. The need to balance the budget of the investor in expectation (second best environment) generates a trade-off between delaying investment and rationing consumers, whenever the demand exhibits variable price elasticity. We argue that the contract should end as soon as the firm obtains a predetermined amount of market revenues. Whenever the firm bears the market risk, the second-best duration of contract is expected to be as long as the assets life, even though when the market goes down cost recovery becomes impossible. On the other hand, when the firm is fully insured, the supply path is distorted downwards from the second best case. Consequently, the timing of investment is delayed and the expected contracting period is reduced.


II. Capacity Investment


Capacity Planning under Uncertainty
Tarik Driouchi, Aston Business School, UK
David Bennett, Aston Business School, UK
Giuliana Battisti, Aston Business School, UK

This short paper introduces the concept of Asian options in the capacity choice literature. We develop a simple model for optimal capacity setting under average demand uncertainty for a single firm. When the firm faces moderate or significant stochastic demands in its current product line, expanding capacity is beneficial. If the demand is extremely stochastic, a capacity lag or reduction is more profitable.

Valuing Capacity Investment Decisions: Binomial vs. Markov Models
Dalila B. M. M. Fontes, University of Porto, Portugal
Fernando A. C. C. Fontes, University of Minho, Portugal

In this work, we present a model to value capacity investment decisions based on real options. In the problem considered we incorporate partial reversibility by letting the firm reverse its capital investment at a cost, both fully or partially. The standard RO approach considers the stochastic variable to be normally distributed and then approximated by a binomial distribution, resulting in a binomial lattice. In this work, we investigate the use of a sparse Markov chain, which is derived from demand data previously collected. The main advantages of this approach are: i) the Markov chain does not assume any type of distribution for the stochastic variable, ii) the probability of a variation is not constant, actually it depends on the current value, and iii) it generalizes current literature using binomial distributions since this type of distribution can be modelled by a Markov chain.

Sequential Irreversible Investment and Capacity Expansion
Xia Su, University of Bonn, Germany
Frank Riedel, University of Bonn, Germany

This paper develops a general theory of sequential irreversible investments in capital where a firm has the option to expand its current capacity or just wait for better time. Facing economic uncertainty, the firm has an operating function of the current capacity and an exogenous stochastic factor modelled by semimartingale. This general model encompasses all previously studied models, including the deterministic case as well as the stochastic case with Geometric Brownian motions, Levy processes and even with regime shift. In this paper, general existence and uniqueness results are first provided for irreversible investments with finite and infinite horizon, respectively. As the main contribution of this paper, a new method is proposed to characterize the optimal investment policy, the base capacity policy. Under the policy, the capacity is kept always at or above the base capacity which is characterized by a stochastic backward equation. This new method gives a number of new qualitative insights into the nature of the irreversible investment. It is demonstrated that the optimal policy equals the marginal operating profit and the user cost of capital in those free intervals when the irreversibility constraint does not bind. While, the equality holds true only on average in block intervals when no investment occurs. Besides, this method easily leads to some general comparative statics results: When the operating profit function is supermodular, the base capacity increases monotonically with the exogenous shock; and the firm size always declines with the user cost of capital. Finally, explicit solutions are derived when the exogenous economic shocks are modelled by Levy processes and the operating profit function is of Cobb-Douglas style.


3.45 - 5.00
I. Competition


Credible Capacity Preemption in a Duopoly Market under Uncertainty
Jianjun Wu, University of Arizona, USA

This paper explores firms' incentives to engage in capacity preemption using a continuous-time real options game. Two ex ante identical firms can choose capacity and investment timing regarding the entry into a new industry whose demand grows until an unknown maturity date, after which it declines until it disappears. Previous literature usually predicts that the Stackelberg leader, whether endogenously or exogenously determined, is better off by building a larger capacity than its rival. In contrast, this paper proves that, under certain conditions about the demand function and the market growth rate, in equilibrium the first mover enters with a smaller capacity. If it had chosen the larger capacity, its competitor could, and in fact would use a smaller plant to force it out of the market. The result is driven by two facts: first, the large capacity firm lacks the incentive to preempt its competitor, because of its higher option value, which tends to delay its investment; second, the large firm also lacks commitment to fight for the market if its leadership is challenged by a smaller firm, because the smaller firm can credibly commit to stay in the market.

Strategic Investment Games Between Two Asymmetric Firms
Jean Kong, Hong Kong University of Science and Technology
Yue Kuen Kwok, Hong Kong University of Science and Technology

This paper examines strategic investment games between two firms that compete for optimal entry in a project that generates uncertain revenue flows. Under asymmetry on both the sunk cost of investment and revenue flows of the two competing firms, we investigate the value of real investment options and strategic interaction of investment decisions. We provide a complete characterization of pre-emptive, dominant and simultaneous equilibriums by analyzing the relative value of leader’s and follower’s optimal investment thresholds. In a duopoly market with negative externalities, a firm may prevent loss of real options value by selecting appropriate pre-emptive entry. Under positive externalities, firms do not compete to lead.

Industry Dynamics and Limit Pricing under Uncertainty
Sebastian Gryglewicz , Tilburg University, Netherlands
Kuno J.M. Huisman, Tilburg University, Netherlands
Peter M. Kort , Tilburg University and University of Antwerp, Belgium

This paper studies the entry deterring limit pricing model in a continuous time and in the presence of market uncertainty. Strategic considerations are reacher than in the standard two-period model. Entry deterring limit pricing is only possible within lower and upper bounds of the market size and if the incumbent is stronger than the potential entrant. No limit pricing arises in separating equilibria. Moreover, higher uncertainty induces higher incidence of entry deterrence.


II. Operating Capacity and Asset Renewal


Market Risk and Process Uncertainty in Production Operations
Bardia Kamrad, Georgetown University, USA
Keith Ord, Georgetown University, USA

By adopting a real options framework we develop a production control model that jointly incorporates process and market uncertainties. In this model, process uncertainty is defined by random fluctuations in the outputs’ yield and market risk through demand uncertainty for the output. In our approach, production outputs represent commodities or items for which financial contracts do not trade. Outputs are also functionally linked to the level of input inventories. To extend the model’s applicability to a wide range of production industries, inputs are modeled to reflect either renewable, or partially renewable or non-renewable resources. Given this setting, techniques of stochastic control theory are employed to obtain value maximizing production policies in a constrained capacity environment. The rate of production is modeled as an adapted positive real-valued process and analogously evaluated as a sequence of complex real options. Since optimal adjustments to the rate of production also functionally depend on the outputs’ yield, we optimally establish “trigger boundaries” justifying controlled variations to the rate of production over time. In this context, we provide closed form analytic results and demonstrate their robustness with respect to the stochastic (including mean reverting) processes considered. Using these results, we also demonstrate that the value (net of holding costs) accrued to the producer from having an inventory of the output is equivalent to the producer’s reservation price to operationally curb its process yield. These generalizations extend the scope of model applicability and provide a basis for applying the real options methodology in the operations arena. The model is explored numerically using a stylized example that allows for both output and demand uncertainty and achieves greater realism by incorporating an element of smoothing into the sequence of production decisions.

Optimality in Asset Renewal Decisions
Roger Adkins, University of Salford, UK
Dean Paxson, Manchester Business School, UK

Using the framework of real options, we develop a model and derive the optimal solution for the case of asset renewal. In contrast to capital replacement of physical assets, the applicable contexts for asset renewals are those in the service sector such as hotels, commercial web-sites and human resources, where the decision to renew depends on both the revenue the asset generates and the operating and maintenance cost it incurs. An analytical solution is derived for the model involving the two distinct but stochastically dependent sources of uncertainty without recourse to homogeneity of degree one to reduce the model’s dimensionality. We find that under plausible conditions the value of the existing asset plus its renewal option is an increasing function of the underlying volatilities while the trigger level for revenue signalling renewal is a decreasing function. In the presence of increasing uncertainty, patience has to be exercised before making the renewal decision. Further, the capital outlay required for renewal, the discount rate and the change rate for cost have a negative effect on the value of the existing asset plus its renewal option and on the trigger level for revenue while the starting revenue following renewal and the change rate for revenue have a positive effect. Finally, we determine the conditions under which homogeneity of degree one can be justified and show that these conditions are not upheld for the present analysis.

Equipment Choice under Interest Rate Uncertainty
José Carlos Dias , ISCTE Business School and ISCAC, Portugal
Mark Shackleton, Lancaster University, UK

Considering interest rate uncertainty to be a relevant variable for the firm’s replacement decision problem we show that standard textbook approaches for replacement investment decisions can lead to non-optimal decisions in a stochastic interest rate environment. The problem with traditional approaches is that the real options related with subsequent replacement choices are not considered, i.e., the managers’ flexibility to switch between assets or equipments with different durability and expendability at each renewal time in response to some stochastic feature are completely ignored from the analysis. To overcome and highlight the shortcomings of the traditional approach presented in the academic textbooks we tackle the replacement investment problem in two ways. First, we consider the problem in a deterministic interest rate economy assuming that the only source of uncertainty is a permanent shock to a flat term structure of interest rates at a specified future date. Then, we consider the replacement problem under stochastic interest rates more explicitly in a CIR economy. The resulting formulae are explicit and quite easy to implement involving only numerical integration in the stochastic case. The solution to this problem seems to be extremely useful for corporate and public institutions managers when revenue or cost streams are relatively static and investment is driven by interest rate uncertainty since depending on the interest rate levels, interest rate volatility and the optionality to switch between durable and expendable assets at each renewal time managers may prefer to invest in long-lived but more expendable assets instead of short-lived but less costly assets and vice-versa.



8.30 - 10.10
I. Case/Industry Applications & Modeling


Real R&D Options: A Two-Factor Jump Model Applied to Biotechnology
Wilson Koh, Manchester Business School, UK
Dean Paxson, Manchester Business School, UK

We first derive explicit formulas for a real perpetual American call option assuming asset price follows a double-exponential jump diffusion process. Similar analytical computation is extended and applied to a research and development (R&D) effort with two stochastic factors. Both project value and investment costs summarise our uncertainties in creating investment opportunities. The presence of Levy jumps underline significant positive and negative impacts on the project's future cash flows and therefore the investment decision. We then apply the theoretical models to an empirical biotechnological R&D case scenario. In our gene-based drug application, we find that an R&D project that experiences mixed-exponential jumps encourages postponement of optimal timing to entry compared to its counterpart that follows a Poisson jump process.

Deployment of Wi-Fi Networks in Enterprise Market: An Application in Wireless Data Services
William Ramirez, Cingular Wireless, USA
Fotios C. Harmantzis, Stevens Institute of Technology, USA
Venkata Praveen Tanguturi , Stevens Institute of Technology, USA

The paper focuses on wireless data services and its importance in enterprise segment market. Currently operators offer wireless services using different technologies to their customers. We look at the problems faced by services providers in provisioning of services in difficult-to-reach areas of tall buildings. Operators are deploying ad-hoc solutions for example; dedicated base stations antenna systems to extend the coverage areas while incurring additional expenses. We propose four alternative deployment solutions from both the corporate customer and service provider point of view. The objective is to maximize the revenues and reduce risk for operators and improve customer satisfaction levels within the budget constraints of the customer. The paper uses real options technique to evaluate the proposed business models. Our analysis suggests savings due to improvements in productivity are much higher than revenues perceived by service provider.

Investment in Hightech Industries: An Application in the LCD TV Industry
Pauline 't Hart, EIM BV, Netherlands
Kuno Huisman, Tilburg University, Netherlands
Peter Kort, Tilburg University and University of Antwerp, Belgium
Joseph Plasmans, Tilburg University and University of Antwerp, Belgium

In this paper we study investments of firms in hightech industries. Typical examples are producers of consumer electronic products such as dvd players, LCD television sets, digital photo cameras, and mobile phones. There are two important characteristics in these markets. The first is (sharply) decreasing sales prices and the second is decreasing production costs. The introduction of new technologies shortens the life cycle of products. Furthermore, innovations in the production process reduce production costs and prices. The latter effect is strengthened by competition. First we develop a standard real options investment model in which the sales price and the unit production costs per unit both follow geometric Brownian motions. However, using real life data from the LCD industry, we show that the sales price can not be described by a geometric Brownian motion. Consequently, a new real options model in discrete time is developed that fits to the real life data. Finally, the two resulting investment strategies of the models are compared.

Lease Contracting and Licensing Agreements: Application to Retailing
Timothy Riddiough, University of Wisconsin - Madison
Joeseph Williams, Professors Capital

A model of bilateral trade between an upstream supplier and a downstream producer is constructed, in which the upstream supplier confers long-term property usage rights to the downstream supplier in return for a base rental fee plus a percentage of verifiable sales production. Our model allows for the possibility that downstream sales production complements other activities of the upstream supplier to increase its total revenues. An optimal contract is designed that balances ex ante investment incentives of the downstream producer with ongoing reinvestment incentives of the upstream supplier. A number of important stylized facts associated with retail lease contracting are addressed, including why: i) retail leases contain base rents and often (but not always) contain an overage rental feature, ii) stores that generate greater externalities pay lower base rents and have lower overage rent percentages than stores that generate fewer externalities, iii) the overage rent option is typically well out-of-the-money at contract execution, and iv) stand-alone retail operations often sign leases that contain an overage rental feature.


II. Managerial Incentives/Agency Issues


The Impact of Real Options on the Agency Problem
Gabriela Siller-Pagaza, ITESM, Mexico
Elisa Cobas-Flores, ITESM, Mexico

Managers participate in identifying and selecting projects and retain a strong direct control over important decisions of the project: active management may allow a project defer, expand, contract, abandon, or otherwise alter a project at different stages during its operating life, whereas venture capitalists only have the information provided by firms, but they do not know the intimate details of project. The objective of this paper is to demonstrate how flexibilities and uncertainties (real options) faced by projects affect the agency problem, and thus the incentives that principal must put in place to achieve optimal project value. Ours model differs from other similar models in a number of ways. To begin with, our model is theoretical instead of empirical, because option pricing is based on theoretical models. Second, our model is very simple but useful to understand how real options impact the agency problem, incorporating moral hazard in the different alternatives that managers have to invest (real options). In projects under a well-defined line of decisions (projects without real options), agency problem is a concern derived from the information asymmetry, the bounded rationality, and the different utility functions of agent and principal. However, managers may allow a firm defer, expand, contract, abandon, or otherwise alter a project at different stages during its operating life. Hence, the information asymmetry, bounded rationality and differences in utility functions may result in a more noticeable issue in projects facing real options. We concluded that the greater the number of real options embedded in the project, the greater the agency problem involved in it. Accordingly, manager must be encouraged to make decisions that maximize the principal interest, with a higher percentage of project final value.

Accountability, Incentives and Project Cost Governance: Data Analysis of NASA Programs
Said Boukendour, University of Quebec, Canada

This paper develops a rewarding system aiming to ensure accountability and accuracy in projects and programs cost estimation by encouraging the appraisers to bet on their estimate, and to reward them fairly. Fair compensation is defined as the payoffs that one would obtain from the market when taking the same risk. Butterfly spread strategy is used to account and to price this risk using Black and Scholes option pricing model. A set of 72 programs executed by NASA from 1977 to 2003 is used to illustrate the model. The main contribution of the article is to bring together fair valuation and real options for improving cost estimation accuracy and resource allocation efficiency.

Effects of Moral Hazard and Private Information on Investment Timing
Jøril Mæland, Norwegian School of Economics and Business, Norway

This paper analyzes investment timing in the presence of agency conflicts and information asymmetries. It is assumed that an owner of an investment project (a real option) needs specialized expertise in order to make the investment. There are n firms with the required knowledge, and these "expert firms" compete about a contract that gives the contract winner the right to manage the investment. Each competitor chooses an unobserved effort that influences the probability of its investment cost level. When effort is made, each expert firm privately observes its own investment costs, but not the competitors. The winner of the contract is the firm that (truthfully) reports the lowest investment cost. The private information problem increases the critical price of investment compared to the case of no inefficiency. When moral hazard is included in the model, the effect on the trigger value is ambiguous: For a low investment cost, the moral hazard problem mitigates the inefficiency effect due to private information. On the other hand, for high investment cost levels the critical price of investment may increase further. Only in a situation in which there is one expert firm (n=1), does the moral hazard problem always mitigate the inefficiency cost due to private information. The last result is consistent with findings in Grenadier and Wang.

Firm-Specific Human Capital as a Real Option
Mark Cassano, University of Calgary, Canada
Tom Cotrell, University of Calgary, Canada



11.00 - 12.15
I. Theoretical Issues/Ambiguity


Optimal Investment under Ambiguity: The Worst Case for Real Options
Magdalena Trojanowska, University of Antwerp, Belgium
Peter Kort, Tilburg University, Netherlands, and University of Antwerp, Belgium

The purpose of this paper is to derive an optimal decision rule for investment in a finite life project. Extending the standard real option framework, we impose that the firm is ambiguous about the development of profit over time in the sense that it has no perfect information about parameter values governing the profit dynamics. The analysis is based on Knight's distinction between risk and uncertainty and is carried out by dynamic programming in continuous time. We find that ambiguity aversion affects the value of waiting equivocally and thus may accelerate investment. Yet, in the long run a large degree of Knightian uncertainty results in foregoing investment with greater probability than in the absence of Knightian uncertainty.

Investment under Ambiguity with the Best and Worst in Mind
David Schroeder, CREST and BGSE, Germany

Recent literature on optimal investment has stressed the difference between the impact of risk compared to Knightian uncertainty - also called ambiguity - on an investor’s decisions. However, the decision maker’s attitude towards uncertainty is crucial when analyzing his investment decisions given an uncertain environment. By introducing an individual parameter reflecting personal characteristics of the entrepreneur, our simple irreversible investment model helps to explain differences in investment behavior in situations which are objectively identical. This paper shows that the presence of Knightian uncertainty leads in many cases to an increase in the subjective project value, and entrepreneurs are more eager to invest.

Adoption and Discontinuation of Management Accounting Innovation: The Case of Activity-Based Costing
Shu Feng, Boston University, USA
Chun-yu Ho, Boston University, USA

This paper employs real option approach (ROA) to study the decision of ABC adoption and discontinuation under uncertainty. The general idea behind is that investing in ABC system is an option-rights as in financial American call option. The proposed model takes the total annual number of production of a firm as the primary decision variables. The added annual net profits after establishing ABC are considered in deciding the optimal threshold for adoption or discontinuation. Moreover, the difference between the ROA and the net present value (NPV) method is compared. We found that the optimal entry threshold for adoption obtained by the ROA is higher than that obtained by the NPV method. Conversely, the optimal exit threshold for discontinuation obtained by the ROA is less than that obtained by the NPV method. Thus, ROA is more conservative than the NPV method. The difference between these two methods is primarily driven by the option value of waiting before implementing the entry/exit project in the ROA. Keywords: Activity based costing; Management accounting innovations; Real option theory; Investment under uncertainty.


II. Capital Structure Interactions


Corporate Fraud, Risky Debt and Liquidation Policy
Elettra Agliardi, University of Bologna, Italy
Rainer Andergassen, University of Bologna, Italy

This paper develops a real options model in which the interaction between debt, liquidation policy and fraud is studied. A firm, being financed by issuing debt and equity, is allowed to inflate profits engaging in fraudulent behaviour at the cost of being detected, in which case liquidation is forced. It is shown that risky debt always speeds up closure, fraud influences firm value and delays liquidation; moreover, fraud affects the value of risky debt, which increases with fraud intensity. A generalization of the model to the choice of different fraud intensities is also examined.

Interactions Between Financing and Investment Decisions in an Agency Conflict Framework
Ricardo Correia, Manchester Business School, UK
Sydney Howell, Manchester Business School, UK
Peter Duck, University of Manchester, UK
David Newton, University of Nottingham, UK

Interactions between financing and investment decisions in a context of real options represent a challenging field of research (e.g. Trigeorgis (1993) and Mauer and Triantis (1994)). The inclusion of agency conflicts is supported by overwhelming empirical evidence (Long and Malitz (1985), Rajan and Zingales (1995), Mackay (2003)). Although there have been recent important (Childs et al. (2005), Mauer and Sarkar (2005)) there is still much to be done. In this paper we analyse a model of the conflicts between equityholders and debtholders regarding the optimal exercise moment of an investment option partially financed by a commitment loan. We assume time constraints for both the investment option and the subsequent firm. For the firm we consider a fixed maturity irrelevant of the moment when the investment option is exercised, aiming at a better reflection of the reality of many real options projects (e.g. petroleum explorations, mining firms, pharmaceuticals). Our results support the coexistence of two different incentives (overinvestment and underinvestment) in one single type of real flexibility (option to invest) evidencing why perpetual models tend to fail in capturing the true complexity of agency conflicts. Furthermore, we show how overinvestment incentives clearly dominate underinvestment incentives, in terms of their impact in the option value, and how they tend to occur at or close to maturity of the investment option. We present competing predictions for the size of the agency costs and reiterate the impact of the agency conflicts in lowering optimal debt levels. Finally we demonstrate why different measures for the agency costs must be considered (in an approach similar to Leland (1998) and Mauer and Sarkar (2005)) in order to correctly capture their full implications.

Investment Options with Debt Financing Constraints
Nicos Koussis, University of Cyprus
Spiros Martzoukos, University of Cyprus

on the Mauer and Sarker (2005) model that captures both investment flexibility and optimal capital structure and risky debt, we study the impact of debt financing constraints on firm value, the optimal timing of investment and other important variables like the credit spreads. The importance of debt financing constraints on firm value and investment policy depends largely on the relative importance of investment timing flexibility and debt financing gains. In cases where investment flexibility has high relative importance the firm can mitigate the effects of debt financing constraints by adjusting its investment policy. We show that these adjustments are non-monotonic and may create a U shape of the investment trigger as a function of the degree that debt is constrained. We show that in a reduced investment horizon, constraints have a more significant impact on firm value. We also consider managerial pre-investment risky growth options (e.g. R&D, or pilot projects). We see that they reduce the maturity effect, and (in contrast to the Brownian volatility) they tend to reduce expected credit spreads.

Thursday | Friday | Saturday



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