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Annual International Conference on Real Options: Theory Meets Practice

15th Annual International Conference
June 15-18, 2011

Turku, Finland

Organized by

Real Options Group
Real Options Group

In cooperation with
Aalto University
Northwestern University
University of California, Los Angeles

Biomass and Carbon Capture and Storage Technologies: The Influence of Learning Effects
A Laude (U of Orléans, France)
C Jonen (U of Köln, Germany)
Combining bioethanol production and Carbon Capture and Storage technologies provides a opportunity to create negative emissions while producing biofuels.This article tackles carbon price uncertainty and technological uncertainty through a real option approach. We first compare the case of an early versus a delayed CCS deployment. An early technological progress may arise from aggressive R&D and pilot project program. We show thus that the amount of avoided emissions is higher and that investments are carry out sooner but after 2030. In a second set of experiments, we apply an additional aid which consists in rewarding sequestered emissions rather than avoided emissions.

Climate Policy Uncertainty and Investment Behavior: Evidence from Small Hydropower Plants
S-E Fleten
AM Heggadal (NTNU)
K Linnerud (CICERO, Norway)
We consider how investors in small hydropower plants respond to climate policy uncertainty. More specifically, we examine whether uncertainty with respect to the subsidy regime has affected the timing of investments in small hydropower plants in Norway. We use real option theory (Dixit and Pindyck, 1994) to translate climate policy uncertainty into investment risk. Based upon panel data of 214 licenses to build small hydropower plants for the period 2001-2008, we can judge whether development did actually occur at the optimal point predicted by the option-based model. Our benchmark is the traditional net present value model.

New Product Development Timing: Switching Options in the Face of Volatile Material Prices
JH Fisch
J-M Ross (U of Augsburg, Germany)
In spite of the performance impact of timing new product development, the literature pays little attention to its influencing factors. Using a real option perspective, this paper develops and tests a model that combines waiting and switching options to analyse the impact of material price fluctuations on the delay of a material substitution project. This study shows that project duration and competitive preemption reduce the decelerating effect of uncertain prices of the new material on the start of development. Uncertain prices of the old material increase the propensity to delay the project.

Valuing an Exhaustible Resource with Stochastic Convenience Yield and Stochastic Extraction Cost: The Case of the Alberta Oil Sands
A Almansour
M Insley
Tirjanto (U of Waterloo, Canada)
In this paper, we study the impact of the stochastic convenience yield and stochastic extraction cost on the value of a nonrenewable resource. A perfect example where volatility of extraction cost appears to be prominent is in the oil sands industry where a substantial amount of natural gas, which has volatile prices, is used during extraction and upgrading activities. The valuation problem is solved using Least Square Monte Carlo (LSMC) simulation proposed by Longstaff and Schwartz (2001) for valuing American financial options.

Long-term Economic Relationships and Correlation Structure in Commodity Markets
J Casassus (PUC, Chile)
P Liu (Cornell U, USA)
K Tang (Renmin U, China)
This paper finds that the long-term co-movement among commodities is driven by economic relations, such as, production, substitution or complementary relationships. Our multi-commodity model disentangles a short-term source of co-movement from the long-term component allowing for a flexible correlation structure. We find that long-term relations are pervasive and significant, both, statistically and economically. The long-term economic relationship considerably reduces the long-term volatility of the spread between commodities which implies lower spread option prices. An out-of-sample test using short-maturity crack spread options data shows that our model considerably reduces the negative bias generated by traditional models.

Forest Harvesting with Multi-Factor Uncertainty
R Adkins
D Paxson (U of Manchester, UK)
We provide a multi-factor real option model for a single forest harvest, for single factor perpetual rotations, and for multi-factor perpetual rotations. We examine separate stochastic forest growth and timber prices, focusing on the forester's critical factors.

Incorporating Managerial Information into Valuation of Early Stage Investments
S Jaimungal
Y Lawryshyn (U of Toronto, Canada)
In this work, we propose a real options (RO) approach that utilizes managerial cash-flow estimates to value early stage project investments. By introducing a sector indicator process which drives the project-value we match arbitrary managerial cash-flow distributions. The project value then becomes a strip of contingent claims on the sector indicator and the option to invest in the project becomes a compound option. This framework can be easily used to value managerial flexibilities and obtain. Furthermore, our approach is consistent with financial theory, requires minimal subjective input, and bridges the gap between theoretical RO frameworks and practice.

Selecting a Balanced R&D Portfolio
G Enea
G Lo Nigro (U of Palermo, Italy)
The R&D process in the pharmaceutical industry has a long and dynamic life then it is an ideal field of application for ROA. Actually, ROA implementation, as widely demonstrated in literature, is narrowed to very limited cases because its perceived complexity.
This research wants to suggest a simplified method, respect the ones available in literature, that could foster the use of ROA: we built up an integer linear programming model, based on a model available in literature, useful for selecting a balanced R&D portfolio from a set of candidate drugs. The model has been tested through a case study.

Human Capital Investment and the Value of Risky R&D Projects
E Dockner (WU Vienna U of Economcs and Business, Austria)
B Siyahhan (Aarhus School of Business, Denmark)
We consider a firm that employs human capital to make a technological breakthrough. The stochastic exogenous value of the patent determines the firm’s decisions to invest in human capital, to abandon the project and to market the new product. Firm value is driven by fixed labor costs, the options to invest in human capital and market the product and the option to abandon the project. Furthermore, firm risk is inverse U-shaped and critically depends on the option to increase the stock of human capital, operating leverage arising from labor costs and the option to abandon if patent values are unattractive.

The Option to Switch from Oil to Natural Gas in Active Offshore Petroleum Fields
O Dahl Hem
S-E Fleten
V Gunnerud
A Svendsen (Norwegian U of Science and Technology, Norway)
An important decision in the development of a mixed oil and natural gas field is whether to produce or re-inject the gas. There is a trade-off between the income from the sale of natural gas and the higher oil production obtained from re-injection. We consider the optimal timing problem of when to switch from oil to natural gas. Our real options valuation prices the switch option significantly higher than a net present value approach. A two-factor price model is implemented for both the oil price and the gas price. The valuation is based on the Least-Squares Monte Carlo simulation algorithm.

Valuing Flexible Facilities with Real Input-Output Switching Options
R Adkins
D Paxson (U of Manchester, UK)
We provide quasi-analytical solutions for multiple and single switching options when both inputs and outputs are stochastic, and there are switching costs. An illustrate is given of natural gas as input and crude oil as output, with suspension, or abandonment options.

Optimal Investment Strategies for Product-Flexible Manufacturing Systems under Demand Uncertainty
V Hagspiel (Tilburg U, Netherlands)
This paper studies the optimal investment strategy of a firm having managerial freedom to acquire both flexible and dedicated manufacturing capacity. The flexible capacity is more expensive but allows the firm to switch costlessly between products and handle changes in relative volumes among products.
We model the investment decision of a monopolistic firm, selling two products in a market characterized by uncertain demand. The firm can choose timing as well as the quantity of investment and is free to either undergo investment in one step at a single freely chosen point of time or in incremental steps at distinct time.

Temporary Unemployment Regulations
K Huisman(Tilburg U, Netherlands)
J Thijssen (U of York, UK)
In this paper we want to analyze the economic impact of the temporary unemployment regulations that a lot of governments of European countries have created during the last credit crunch recession. First we analyze when a representitive firm should exit the market if there is not such regulation. Second we study the effect of such regulation by deriving the optimal exit point for firm that uses the regulation. Third we take the government view on the topic and determine when it is optimal time from a welfare perspective to introduce such regulation.

Strategic Renegotiation Options in US Residential Mortgages
M Flanagan (Manchester Metropolitan U)
D Paxson (U of Manchester, UK)
In the current US housing crisis, borrowers may choose to defer a mortgage payment in order to mitigate a cash flow problem or improve their equity position. This option is available when the lender does not automatically foreclose on the delinquent borrower. Invariably, a negotiation commences between lender and borrower, each motivated by different sets of objectives. We model those negotiations by considering future unavoidable foreclosure costs. We derive closed form solutions for the optimal ex ante mortgage loan terms, such as LTV and coupon payment, offered by a lender to a borrower with a strategic delinquency option.

Investment Decisions in Monopolies Under Random Change in Market Structure
P Pereira (U of Porto)
A Rodrigues (U of Minho, Portugal)
We study the demonopolization process of granted monopolies. This processes may have different origins such as changes in the policy of a government or a regulator, or new invention or innovation competing with existing patented ones. The demonopolization of the market represents a threat for the granted monopolist and is a relevant source of risk. In the existing real options literature, the market structure is assumed to be steady state, not allowed to change. In this paper, this assumption is relaxed. Here a monopolistic firm faces the threat of demonopolization, that changes the market structure to a duopoly market.

Valuing a Multi-stage Hydrogen Infrastructure Investment with Barrier
Y Li
P-J Engelen
C Kool
T Poot (Utrecht U, Netherlands)
An investment failure often occurs unexpectedly and involves significant losses to the project value. It makes a great similarity to a default event preventing the investor paying back its debt. We aim to link the two theories, where a failure is determine through the evolution of firm’s underlying value.The value of underlying investment itself is modeled as a two-dimensional Geometric Brownian Motion with correlated market and technological uncertainties. Together with the barrier, its variation will be downside bounded, which will be considered as the value of a low market penetration in hydrogen transitions. And further adopted in energy scenario studies.

Investment in High Speed Rail Transport under Uncertainty
G Couto (U of Açores)
I Ferrreira (IST)
C Nunes (IST)
P Pimentel (U of Açores, Portugal)
In the present paper we derive the optimal investment policy of investment in the HSR project. We assume that the HSR demand follows a geometric brownian motion with random jumps. Furthermore, we assume that the investment follows a geometric Brownian motion, and we analise both situations: independence vs dependence of the processes.
We assess the impact of these shocks in the demand threshold, along with the investment opportunity value and option to differ. We consider several distributions for these jumps, and we compare with the no-jumps case. Numerical results are presented, showing the importance of assumptions about the stochastic processes.

Economic Capacity Withholding: Effects of Power Plant Operational Characteristics on Optimal Dispatch Decisions
N Misir (Copenhagen Business School, Denmark)
In this paper we study the effects of operational characteristics of power plants on optimal dispatch decisions for a monopolist. The first aim of this paper is to give a mathematical model to show that the operational characteristics and uncertainty result in economic withholding. In this regard, we’ll be able to identify effects of these operational characteristics on the market price. Operational characteristics include: total maximum production capacity, minimum oper- ation level, start-up and shut-down costs. Firms in the industry adjust their production or take start-up/shut-down decisions for their power plants according to realization of industry-wide exogenous demand shocks. We show that in the case of ownership of multiple generation technologies, optimal dispatch decisions will cause economic withholding at peakload level. Therefore, more costly generation unit will start when market price is well above its marginal cost. This result also holds for corresponding social planner’s problem. Hence, we can distinguish between the effects of market power and optimal dispatch decisions on market prices.

Strategic Investment Among Asymmetric Firms in Oligopoly
M Kijima
S Ko
T Shibata (Tokyo Metropolitan U, Japan)
This paper studies strategic interaction of multiple firms under the assumption of asymmetric sunk cost and profit flow. We estimate the value of each firm and characterize the optimal investment thresholds. We also provide a numerical example on the equilibrium strategies in a three-firm setting.
One of main result is that all firms act later than in those under symmetric case. Another important result is that the first investment threshold in an oligopoly market has three kinds of value. This result is strikingly different from the symmetric case where the first investment threshold is always larger than duopoly market.

Patent-Investment Preemption Games under Asymmetric Information
CM Leung
YK Kwok (Hong Kong U of Science and Technology)
This paper analyzes preemptive patenting in a two-stage real options game where an incumbent firm competes with a potential entrant firm for the patent of a substitute product in a product market with profit flow uncertainty. The incumbent suffers loss of monopoly in the prod- uct market if the entrant acquires the patent of a substitute product and later commercializes the product. Our patent-investment game model assumes that the entrant has complete information on the in- cumbent’s commercialization cost while the incumbent only knows the distribution of the entrant’s cost. We investigate the impact of infor- mation asymmetry on the preemption strategies adopted by the two competing firms on patenting the substitute product by comparing the optimal preemption strategies and the real option value functions of the two competing firms under complete information and informa- tion asymmetry. Our analysis reveals that the informationally disad- vantaged incumbent always suffers from loss in its real option value of investment since it tends to act more aggressively in competing for the patent. On the other hand, the real option value of invest- ment of the informationally advantaged entrant may be undermined or enhanced. The incumbent’s aggressive response under information asymmetry may lead to reversal of winner in the patent race. We also examine how information asymmetry may affect the occurrence of sleeping patent and the corresponding expected duration between the two stages of patenting and product commercialization.

Preemptive Capacity Investment under Uncertainty
B Chevalier-Roignant
A Huchzermeier (WHU, Germany)
L Trigeorgis (U of Cyprus)
The incentive to "overinvest" in capital may be eroded in dynamic, competitive settings if firms face uncertainty and irreversibility. In this paper, we derive the stationary Markov perfect equilibrium for a dynamic, infinite-horizon capacity investment game formulated in continuous time in which reduced-form profits are subject to industry shocks. We show that the theory of marginal Tobin's q still holds in capital-accumulation games under uncertainty if the strategic externalities of rivals' investment are properly accounted for.

Valuation of the Options to Expand and Verticalize a Fertilizer Investment
H Brasil (IBMEC Minas Gerais)
A Aronne (U of Verona)
A Rajão (Brazil)
This paper presents criteria for the valuation of real options in a project of exploitation and production of fertilizers. The option to expand the project and the option to verticalize it are modeled and analyzed. Results indicate that they represent substantial source of value for the owners of the project.

Pollution Reduction Policies under Uncertainty
M Tsujimura (Doshisha U, Japan)
In this paper, we investigate pollutant reduction policies under uncertainty. We assume that when an agent reduces quantity of a pollutant, it incurs costs. We consider two kinds of policies distinguished by their costs. One policy incurs proportional reduction cost (Case 1) and the other incurs fixed and proportional reduction costs (Case 2). To solve these problems, we formulate the agent's problems as a singular stochastic control problem in Case 1 and a stochastic impulse control problem in Case 2, respectively. Using this analysis, we show optimal pollutant reduction policies. Furthermore, we present numerical analysis.

Reversibility and Switching Options in the Geological Disposal of Radioactive Waste
O Ionescu (Strasbourg U/Nancy U)
S Spaeter (Strasbourg U, France)
In this paper we construct a real options model in a continuous time framework to study the decision problem in the French reversible repository for the radioactive waste, with multiple disposal stages. These stages are differentiated by the degree of the retrievability of the ultimate waste packages. The decision maker’s problem is then the choice of the disposal stage maximizing the value of the reversible project according to multiple uncertainties and irreversibility of costs. Given the sequentiality and the reversibility of the decision, the project implies a series of compound options, which need to be evaluated simultaneously.

Investment under Uncertainty: Equilibrium between Competition and Cooperation
Y Li (Ryerson U, Canada)
G Sick (U Calgary, Canada)
Competition hastens real options development. Supply-side heterogeneity can offset this effect. Our model extends this to a situation where there can be competition and cooperation amongst parties in an industry. They produce a commodity that is exogenously priced, but have to decide whether to share some production facilities that have scale economies. There is heterogeneity in size and firm-specific costs, so they do not have the same incentives. A natural leader offers to build common infrastructure and lease access to competitors who have reservation prices and can either build their own or delay their own entry into the market.

Holdup Problems in Early Supplier Involvement and New Product Development Performance
W Margsiri
S Wu (Fordham U, USA)
This study examines the dynamic relationship between the manufacturer and supplier using cooperative investment framework, and argues that post-contractual holdups can reduce the benefits from the collaboration, leading to a longer development lead time and a lower probability of a radical innovation. These problems cannot be solved by monitoring or standard contracts. The study offers insights for manufacturers deciding whether to strategically commit to their suppliers. While the commitment strategy increases the suppliers’ incentive to collaborate, the non-commitment strategy reduces holdup problems. Two key contingent factors that influence the manufacturer’s commitment strategies and involvement timing are identified.

Tacit Collusion in Investment Timing
EB de Villemeur (IDEI)
R Ruble
B Versaevel (EM Lyon, France)
We provide characterizations of tacit collusion (simultaneous) equilibrium in models of investment timing allowing for spillovers in both flow profits and investment costs. We validate these characterizations by applying them to common models of capacity accumulation and R&D investment, as well as to investment in an endogenously priced input. For instance, in linear demand Cournot competition, tacit collusion is likelier to arise when installed capacities and lumpy investments are both large.

Contract Design for Optimal Investment Decisions
D Cardoso
P Pereira (U of Porto, Portugal)
Agency conflicts frequently occur. This may have a major impact on the value maximizing decision. This paper contributes to the scarce literature that accounts for agency problems on the exercise of real options, proposing a model which allows to set an optimal contract structure in order to avoid inadequate actions from the manager. In our model, shareholders need not to follow the future evolution of project value drivers in order to guarantee optimal behavior. We show that even small deviations from the optimal compensation scheme may lead to highly sub-optimal decisions. Optimal contracts are also established for some special situations.

Ambiguity Aversion in Real Options
S Jaimungal (U Toronto, Canada)
Real option valuation has traditionally been concerned with investment under project value uncertainty while assuming the agent has perfect confidence in a specific model. However, agents do not generally have perfect confidence in their model and this model uncertainty affects their decisions. In this work, we introduce a simple model for real option valuation to account for the agent’s aversion to model ambiguity through the notation of robust indifference prices. We derive analytical results for the perpetual option to invest and the linear complementarity problem that the finite time problem satisfies.

The Effect of Costly Exploration on Optimal Investment Timing
M Nishihara (Osaka U)
T Shibata (Tokyo Metropolitan U, Japan)
This paper investigates a principal-agent model in which an owner (principal) optimizes a contract with a manager (agent) delegated to undertake an investment project. We explore the effects of costly exploration by which the manager learns the real value of development cost. We show that high exploration cost can lead to a pooling policy not contingent on project type. Further, we show that, in the presence of asymmetric information, higher exploration cost leads to wealth transfer from owner to manager and can then play a positive role in preventing a greedy contract by the owner and improving social welfare.

The Role of Uncertainty in Real Options Analysis
M Hung (National Taiwan U)
L-C So (National Tsing Hua U, Taiwan)
An adjusted Black-Scholes pricing formula is derived in this paper. By separating risk and uncertainty through the robust control technique, we find that uncertainty as well as risk raises the management’s subjective evaluation of real options. We suggest a simple method to filter the risk of the project and to acquire a more reliable value of real options without the influence of uncertainty. Besides, we propose that one investment opportunity may be postponed inappropriately, since under uncertainty the exercise of investment may be delayed by the project manager.

Uncertainty and Competition in the Adoption of Complementary Technologies
A Azevedo (U of Hull)
D Paxson (U Manchester, UK)
We study the combined effects of uncertainty, competition and “technological complementarity” on firms’ investment behaviour in a leader/follower pre-emption investment game. Our results contradict the conventional wisdom which says that “when a production process requires two extremely complementary inputs, a firm should upgrade (or replace) them simultaneously”. We found that when competition and uncertainty are considered, this is very unlikely to be the case for the leader, and mixed strategies are possible for the follower. Some of the illustrated results show nonlinear and complex investment criteria and significant differences between the leader’s and the follower’s investment behavior.

Duopolistic Competition with Risk Aversion under Uncertainty
M Chronopoulos
B De Reyck
A Siddiqui (University College London, UK)
A monopolist typically defers entry into an industry as both price uncertainty and the level of risk aversion increase. The former attribute may be present in most deregulated industries, while the latter may be relevant for reasons of market incompleteness or technical uncertainty. By contrast, it has been shown that the presence of a rival hastens entry under risk neutrality in certain frameworks. Here, we examine how duopolistic competition affects the entry decisions of risk-averse investors. We also explore how the impact of competition on the value of a firm under two frameworks varies with risk aversion and uncertainty.

Optimal Default and Liquidation with Tangible Assets and Debt Renegotiation
M Couto (Hokkaido U)
M Kijima (Tokyo Metropolitan U)
T Suzuki (Hokkaido U, Japan)
We propose a pricing model for corporate securities issued by a levered firm with the possibility of debt renegotiation, where the firm’s earnings follow a geometric Brownian motion with stochastic collaterals. While equity holders can default the firm when the earnings become insufficient, they may liquidate it by repaying the face value of debt when the value of collaterals becomes sufficiently high. Unlike the existing models, the bivariate structure enables us to distinguish strategic default, liquidity default and ordinary liquidation, which makes the contribution of strategic debt service to credit spreads lower than that obtained in the previous models.

Compensation of High Interest Rates by Tax Holidays
V Arkin
A Slastnikov (Central Economics and Mathematics Institute, Russian Federation)
n economics with increased risks (political, credit etc.) and other unfavorable factors the following compensation problem arises: can tax benefits provide investor with the same conditions (in some sense) for investment as he would have in "standard" economy without any risks and unfavorable factors. Increased credit risks imply increasing interest rates on credit.
We study, in real options framework, the possibility to apply the tax holidays mechanism (on corporate profit tax) for a compensation of high-level interest rates.

Valuing Real Options Using a Jump Process Approximation
S Grillo
G Blanco
C Schaerer (National U of Asuncion, Paraguay)
Real Options were firstly formulated using few underlying assets with European features or American perpetual options, but usually an investor confront with several opportunities. Nowadays, approaches based on simulations have been proposed for solving complex options. This paper proposes an alternative appraisal based on a jump process approximation for multivariate Real Option problems. We discuss the viability of the proposal through a study case of a control chart decision-CCD. The proposal is compared with widely used algorithms for CCD problems. The results show the proposal flexibility in problems where traditional algorithms are not applicable or have poor performance.

Stochastic Discount Factors and Real Options
P Edge (EDP, Portugal)
This paper uses the stochastic discount factor (SDF) to price real options and the expected discounted shortfall (EDS) risk measure to control risk. A multivatiate covariance based SDF modelling framework is described. Explicit formulae linking the correlation matrix to the risk premium are derived. Applying the SDF to real options problems simplifies calculations and economic assumptions by removing the requirement for hedging portfolios. This means that other risk control methods are required. EDS is a coherent, multi-period risk measure that calculates the present value of the shareholder risk that the cashflows are insufficient. A real option case study is included.

Optimal IPO Timing in an Exchange Economy
J Casassus
M Villalon (PUC, Chile)
We model the IPO decision of an entrepreneur in an exchange economy. The entrepreneur holds a Lucas Tree, and when the IPO occurs, the market converges to a Two Trees economy built on Cochrane, Longstaff and Santa Clara. We solve the optimal timing problem and study the diversification effects over the firm's value and entrepreneur's consumption. The model predicts that IPOs should be correlated with the firm's size and explains why firms with lower betas are expected to IPO first.

On a General Market Portfolio Acting as the Twin Security of an Arbitrary Project
M Arai
M Ota
M Mogi (U of Tokyo, Japan)
Necessary conditions of a twin asset to derive the Black-Scholes-Merton partial differential equation (BSM) determining the objective real option values has been discussed and determined. Consequently, perfect correlativity and volatility matching have been determined as the necessary conditions for a twin asset whose value will represent the objective value of a project that could be used for a parameter in the BSM solution. Efficient searching procedure for a portfolio, which satisfies the necessary conditions as a twin asset, has been proposed and the existence of a twin asset with appropriate congeniality for an arbitrary project has been demonstrated.

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