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Annual International Conference on Real Options: Theory Meets Practice

Abstracts and Links to Papers
Seventh Annual
Real Options Conference

July 10-12, 2003, Washington DC

Thursday | Friday Track I | Friday Track II
Keynote Address | Saturday Track I | Saturday Track II


12:00 - 1:00 Registration

1:00 - 2:30 Valuing Acquistions
Chairperson: Alexander Triantis
, University of Maryland


A Real Options Approach to Tender Offers and Acquisitions
Jose Pablo Dapena
, Universidad del CEMA
Santiago Fidalgo, Repsol YPF, Argentina


Corporate control has added value for an investor since it gives degrees of freedom about the use of assets, sources of finance, salaries, etc. On the other hand, real options create value through the flexibility associated to the ability to react to some relevant uncertainty. The process of acquisition of corporate control can have two real options associated, a waiting option and a growth option. In the waiting option value is created through sequential investment instead of investing at once, while the growth option carries all the private benefits the investor can seize from control by making follow up investments, which can also justify premiums paid above the former market price. A relevant proposition of our paper is that the exercise price of the growth option (and hence the amount to be paid as the control premium) can be affected by the release of information. We develop a model for these two theoretical extremes: One where the exercise price fully reacts to events, and one where the exercise price does not react at all, and we obtain that the timing of the process of acquiring control would depend on the reaction of the price to be paid to obtain control, so would the size of the control premium over the former price.


Equity Carve-outs as Acquisitions of Strategic Real Options
Silvia Rossetto
, Université de Toulouse
Enrico Perotti, University of Amsterdam
Marc Kranenburg, University of Amsterdam


Equity carve-outs, the listing of a stake in a subsidiary on the stock market, are empirically transitory arrangements. This paper studies decisions aimed to gaining access to the choice over a "second stage" event, namely either a sell-off or a buy-back decision. Hence, an equity carve out can be seen as a compound option. The decision is driven by learning over strategic synergies between the parent firm and the subsidiary, which evolves stochastically over time. We find that the decisions to carve-out, to buy-back and to sell off are critically influenced by uncertainty over future synergies. We also find that there is an optimal amount of shares sold, which is positively related to uncertainty over future synergies.


A Dynamic Model of Corporate Acquisitions
Betton, Concordia University, Canada
Pablo Morán, Universidad de Talca, Chile


Using a game-theoretic real option approach, this paper presents a model of corporate acquisitions. We incorporate imperfect information about synergy gains, strategic interaction among competing bidders, and between the successful bidder and the target firm. Assuming the absence of managerial motives, the model is able to explain some empirical regularities that have only been explained under the agency and hubris hypotheses. Under valuation, asymmetric distribution of gains, and divestitures are a natural output in our model. This theoretical model suggests that controlling for industry characteristics is an important element in empirical research.


2:30 - 3:00 Afternoon Coffee Break

3:00 - 5:00 Empirical Evidence
Chairperson: Laarni Bulan
, Brandeis University


A Cross-sectional Analysis of Firm Growth Options
Long, Rutgers Business School
John Wald, Rutgers Business School
Jingfeng Zhang, Rutgers Business School


We estimate the present value of growth options (PVGO) for a sample of manufacturing firms. We find that a firm's PVGO is positively related to the firm's R&D, past sales growth, and cash flow volatility. We also find that firms with higher PVGO, and therefore higher irreversible investment opportunities, invest less. This suggests that on average delaying investment maximizes the value of a firm's real options. We also examine the relationship between a firm's PVGO and market structure. We find that firms in more concentrated industries with above median Q are more likely to have higher PVGO. Additionally, more diversified firms have lower PVGO. These results appear to be robust to a number of definitions and controls.


Real Options, Corporate Performance, and Shareholder Value Creation
Cyrus Ramezani
, California Polytechnic


Real Options have proved to be a very useful framework for analyzing corporate investment decisions. While significant progress has been made in identifying and valuing Real Options, two important questions have not been addressed in a systematic manner. First, how does the existence and optimal exercise of Real Options affect managerial performance metrics such Return on Investment (ROI), Return on Assets (ROA), Economic and Market Value Added (EVA and MVA), and other measures of operational efficiency of the firm? Second, do security prices and risk adjusted returns (as measured by Jensen's Alpha) reflect the value of the portfolio of Real Options the firm owns? The purpose of this study is to address these questions. We use cross sectional data for over 3000 firms (Sources: Compustat and CRSP) covering the period 1990-2002 to provide answers to these questions.

Two key ingredients that enhance the value of Real Options are managerial flexibility and the volatility (risk) of the underlying value driver(s). One can then think in terms of a two by tow matrix with four quadrants, with low option values corresponding to low volatility and limited managerial flexibility and high option values corresponding to high volatility coupled with high level of managerial flexibility. The value of Real Options for the other two quadrants lie within these two extremes. We use this scheme to assign firms into the four Real Option value quadrants and compare the performance of firms in each quadrant from the perspective of both the firm's mangers and its shareholders.

We identify several variables as proxies for managerial flexibility and volatility of the underlying risk. For measures of managerial flexibility we use items from the firms' statement of cash flows, including expenditures on investment activity and R&D, and the level of managerial ownership of the firm. When appropriate, we normalize these measures by sales or the market (or book) value of assets to control for firm size. For measures of underlying risk we use volatility of quarterly sale growth, quarterly cash flow growth, and monthly return on the firm's stock. We further decompose the total monthly return volatility into systematic and idiosyncratic components using the standard CAPM framework. This decomposition enables us to access the impact of firm specific risk on the value of its Real Options.

We use the median value of volatility and managerial flexibility measures to assign firms to the four quadrants. The industries in each quadrant are identified from their four digit SIC code. The main industries in the high flexibility-high volatility (HH) quadrant are mining and oil and gas extraction, pharmaceuticals, semiconductor equipment, electronic computers, communications, and computer software. The main industries in low flexibility-low volatility (LL) quadrant are construction, food, newspapers and periodicals, plastic materials and synthetic resins, primary metals, transportation equipment, and general merchandize stores. The main industries in low flexibility- high volatility (LH) quadrant are chemicals, communications equipment, semiconductors, apparel, miscellaneous retail, and direct mail advertising. Finally, the main industries in high flexibility-low volatility (HL) quadrant are oil extraction and refining, food, paper, motor vehicles, and air transpartation.

The impact of Real Options on a number of traditional and value-based corporate performance measures are studies. These include Return on Investment (ROI), Return on Assets (ROA), Economic and Market Value Added (EVA and MVA), Tobin's Q, Price-Earnings ratio, and several measures of corporate profitability. To study the influence of Real Options on stock returns we use Jensen's Alpha for firms in each quadrant. We also calculate the rate of return to an actively managed portfolio (equally weighted) that invests and annually rebalances a portfolio composed of firms in each quadrant (monthly returns for January 1990 through December 2002). We show that performance measures for firms with valuable Real Options are significantly higher than firms without such options. Moreover, we find that risk adjusted and total returns to a portfolio of firms with valuable Real Options are consistently higher than firms without such options or a broad index that represents a passive trading strategy.


Financial and Real Option Hedges Implemented by U.S. Multinational Corporations
Carter, Oklahoma State University
Christos Pantzalis, University of South Florida
Betty Simkins, Oklahoma State University


This study investigates the influence of both financial and operational hedges on the foreign-exchange exposure of U.S. multinational corporations. Three important contributions of our research are: (1) we provide evidence that exposure of U.S. MNCs to foreign-exchange risk is asymmetric; (2) our results demonstrate that both operational and financial hedges can effectively reduce foreign-currency exposure; and (3) we find evidence suggesting that operational hedges serve as real options in that exposure varies not only as to whether the firm is a 'net importer' or 'net exporter' but also across weak and strong dollar states. Prior research assuming symmetric exposure to foreign-exchange risk may be need to be re-evaluated in light of our finding that many MNCs have asymmetric foreign-exchange exposures.

JEL Classification: F30, F31, G15 Key words: Multinational finance, Foreign exchange risk, Operational hedges, Real options, Currency derivatives


Irreversible Investment, Real Options and Competition: Evidence from Real Estate Development
Laarni Bulan
, Brandeis University
Christopher Mayer, University of Pennsylvania
Tsur Somerville, University of British Columbia


We examine 1,214 condominium developments in Vancouver, Canada between 1979-1998 to identify the extent to which uncertainty delays investment. We find that increases in both idiosyncratic and systematic risk lead developers to delay new real estate investments. Empirically, a one-standard deviation increase in the return volatility reduces the hazard rate of investment by 13 percent, equivalent to a 9 percent decline in real prices. Increases in the number of potential competitors located near a project negates the negative relationship between idiosyncratic risk and development. These results support the argument that competition erodes option values and provide clear evidence for the real options model of investment under uncertainty over alternatives such as simple risk aversion.


Financial Innovation, Strategic Real Options and Endogenous Competition in Internet Banking
David Nickerson
, Colorado State University and Freddie Mac
Richard Sullivan, Federal Reserve Bank of Kansas City


Innovations in financial services continuously influence the scope of financial intermediation and the nature of competition between intermediaries. This paper examines the optimal exercise of strategic real options to invest in such an innovation, Internet banking technology, within a two-stage game, parameterized by the distribution of bank size and uncertainty over the profitability of investment, and empirically tests the results on a novel data set. Unlike traditional options, in which the distribution of the future value of the underlying asset is exogenous and the timing of exercise affects only the return to the option holder, the timing of the exercise of real options in a strategic context allows the option holder to manipulate the distribution of returns to all players. The value of the strategic investment option in our model, as a consequence, depends on both expected future profits as well as the variance of those profits. Expected profits to an entrant depend, in equilibrium, on its size, as measured by existing market share (concentration) or total assets, relative to its rivals. Conditional on the degree of uncertainty, larger banks should, as a consequence, exercise their options earlier than smaller banks, for purely strategic advantages, and act as market leaders in the provision of Internet banking services. Like ordinary options, however, the value of the strategic investment option to both large and small banks increases in uncertainty, implying that early exercise will be more likely the more information is available about potential demand. We test these hypotheses on investment in Internet banking services with data from a sample of 1,618 commercial banks in the tenth Federal Reserve District during 1999. Evidence indicates that relative bank size, as measured by either market share or asset size, positively influences the likelihood of entry into Internet banking, and trend-adjusted variation in income per person (a proxy for uncertainty of demand) negatively influences the likelihood of entry into Internet banking. In addition, market concentration of a bank's competitive rivals has a negative relationship with the likelihood of entering the market for Internet banking services. These relations are evident in both bivariate analysis and in multivariate logit regression analysis.


5:00 - 6:00 Panel Discussion
Valuation, Technology and Corporate Strategy: Current Status, Challenges and Prospects
Moderator: Tom Copeland
, Monitor

Panelists Include:
John McCormack (Stern Stewart & Co.)
Ghene Faulcon (BP Oil)
Kryzysztof Wolyniec (Mirant Corp.)
Gill Eapen (Decision Optics LLC)
Onno Lint (U. Leuven, Belgium)
Dwight Allen (Deloitte Consulting)
Soussan Faiz (ex Texaco)
Peter Damisch (Boston Consulting Group)


6:30 - 8:00 Networking Reception




7:00 - 7:45 Registration and Continental Breakfast


7:45 - 8:20 Chairperson's Welcome & Address

Real Options and Investment Under Uncertainty
Lenos Trigeorgis
, University of Cyprus and President, Real Options Group


Track I

8:30 - 10:00 Conceptual
Chairperson: Adam Borison
, Stanford University

Option Pricing in the Real World: A Generalized Binomial Model with Applications to Real Options
Tom Arnold
, University of Richmond
Timothy Crack, Barclays Global Investors Ltd.


We extend a popular binomial model to allow for option pricing using real-world rather than risk neutral world probabilities. There are three benefits. First, our model allows direct inference about relevant real-world probabilities (e.g., of success in a real-option project, of default on a corporate bond, or of an American-style option finishing in the money). Second, practitioners using our model for corporate real option applications completely avoid the managerial anxiety that competing risk-neutral models generate when they use risk-free discount rates for risky cash flows. Third, our model simplifies option pricing when higher moments (e.g. skewness and kurtosis) appear in asset pricing models.


Uncertainty as a Key Value Driver of Real Options
Johannes Braeutigam
, European Business School, Germany
Anett Mehler-Bicher, University of Applied Science, Mainz
Christoph Esche, European Business School


Real option valuation can be difficult and time consuming. Therefore, we propose a framework which is aimed at facilitating the process of real option valuation and to make it more time efficient. The framework covers not only the valuation of real options but also the organizational- , strategic-, and controlling aspects necessary to apply real option valuation accurately. In particular this paper focuses on uncertainties underlying any real option. Uncertainties will be used not only to identify options but also to link the interaction of uncertainties with the interaction of options. Finally, we will demonstrate the applicability of the framework with a real life e-commerce case study.


Coordination of Investment in Systems of Complementary Assets: A Clinical Study
Peter Miller
, London School of Economics
Ted O'Leary, University of Manchester and University of Michigan


This paper reports the results of a 4-year longitudinal clinical study conducted at executive office levels in Intel Corporation. It seeks to remedy the neglect of firm-level empirical analyses of capital budgeting, and in particular to address the mechanisms used to coordinate investment decisions and associated expectations. The aim is to provide an empirical illustration of recent work that has modelled formally the benefits available when capital spending decisions are structured as complementary investments at both intra-firm and inter-firm levels. Within Intel’s capital budgeting process, we focus on a hitherto neglected mechanism termed a technology roadmap – a mechanism used to ensure that large-scale capital investments made by sub-units of the firm are coordinated with one another, and that they are aligned also with investments made by a wide range of complementor firms, such as OEM customers and developers of operating systems. We describe the technology roadmap mechanism, and examine how it integrates with DCF analyses to permit an individual capital spending proposal to be valued within the system of complementary investments of which it is a part. The contributions of the paper are threefold. First, our findings provide strong, firm-level evidence supporting the arguments of Milgrom and Roberts (1995a, b) and Trigeorgis (1995, 1996) that the system of assets, rather than the individual investment decision, may often be the critical unit of analysis and decision for managers. Second, we find that value-maximising investments in systems of complementary assets require coordination mechanisms that are largely overlooked in recent theoretical literature. Third, we identify issues for investigation in future large-sample surveys and clinical analyses of the capital budgeting process. In particular, we suggest investigating whether there are systematic differences between industries in the effectiveness with which interdependent investments are planned and coordinated across firm boundaries.


Real Options Analysis: Where are the Emperor's Clothes?
Adam Borison
, Stanford University


In the more than 25 years since the term 'real options' was coined by Stewart Myers, several approaches have been proposed for calculating the real-option value of a potential corporate investment. Unfortunately, the assumptions underlying these various approaches and the conditions that are appropriate for their application are often not spelled out. Where they are spelled out or can be inferred, they differ widely from approach to approach and are even contradictory. Furthermore, the difficulties in implementing the different approaches are rarely discussed, and the pros and cons of alternative approaches are not explained. This paper attempts to help remedy this situation by describing, contrasting, and, yes, critiquing the major proposed analytic approaches for applying real options, typically termed "real options analysis" or "real option valuation." The emphasis is on three fundamental issues surrounding each proposed approach: 1. Applicability: what does the calculated real-option value represent, and where is it appropriate to use this calculation? Assumptions: what are the notable assumptions underlying the approach, and what is the evidence regarding the validity of these assumptions? 2. Mechanics: what steps are involved in applying the approach, and what are the associated difficulties? 3. The paper concludes with observations about the relative strengths and weaknesses of the proposed approaches, and specific recommendations on which ones to use in what circumstances.


10:00 - 10:30 Morning Coffee Break


10:30 - 12:00 Valuing Natural Resource Investments
Chairperson: David Laughton
, University of Alberta


Evaluating Natural Resource Investments Using Monte Carlo Simulation
Andrianos Tsekrekos
, University of Durham
Mark Shackleton, Lancaster University
Rafal Wojakowski, Lancaster University


The idea that Monte Carlo simulation can not be applied to the pricing of options (real or financial) with early exercise features has been overridden in the light of new research results in the last decade. This paper attempts to contribute to this revived interest on Monte Carlo simulation valuation, by applying the proposed least--squares simulation method to the valuation of a hypothetical natural resource investment. Results seem to suggest that the Monte Carlo framework might be a natural way forward in the valuation of investments under multiple uncertainties and project--specific complexities.


Real Option Decision Rules for Oil Field Development under Market Uncertainty
Juan G. Lazo
, Pontifical Catholic University of Rio de Janeiro
Marco Aurélio Pacheco, Pontifical Catholic University of Rio de Janeiro
Marley M. Vellasco, Pontifical Catholic University of Rio de Janeiro
Marco Antonio Guimarães Dias, PUC-Rio and Petrobras


A decision to invest in the development of an oil reserve requires an in-depth analysis of several uncertainty factors. Such factors may involve either technical uncertainties related to the size and economic quality of the reserve, or market uncertainties. When a great number of investment alternatives are involved, the task of selecting the best alternative or a decision rule is very important and also quite complicated due to the considerable number of possibilities and parameters that must be taken into account. This work proposes a model based on Genetic Algorithms and on Monte Carlo simulation which has been designed to find an optimal decision rule for oil field development alternatives, under market uncertainty, that may help decision-making with regard to: developing a field immediately or waiting until market conditions are more favorable. This optimal decision rule is formed by three mutually exclusive alternatives which describe three exercise regions along time, up to the expiration of the concession of the field. The Monte Carlo simulation is employed within the genetic algorithm for the purpose of simulating the possible paths of oil prices up to the expiration date, and it is assumed that oil prices follow a Geometric Brownian Motion.

Keywords: Real Options, Genetic Algorithms, Monte Carlo Simulation


Valuation of an Oil Field Using Real Options and the Information Provided by Term Structures of Commodity Prices
Delphine Lautier,
Cereg, University Paris IX Dauphine


This article emphasises that the information provided by term structures of commodity prices has an influence on the real option value and on the investment decision. We exhibit first of all the analysis framework: the evaluation of an oil field. We suppose that a single source of uncertainty - the crude oil price - affects the investment decision. We also present the two term structure models used to represent the dynamic behaviour of this price and to evaluate the net cash flows of the field. Then we present the real options valuation method. Lastly, simulations illustrate the sensibility of the real options to the term structure of commodity prices, and we analyse the investment signals given by the optional method. Our principal conclusions are twofold. Firstly, to understand the behaviour of the real option, it is essential to take into account the information given by the term structure of prices. Secondly, for some specific price curves, the investment signal associated with the optional method does not differ from the one given by the net present value.

KEYWORDS: convenience yield - stochastic models - real option to delay - crude oil - term structure - net present value.


Using Real Options to Analyze the Effect of Contractual Investment Restrictions: The Case of Construction Guarantees
Michael Samis
, Kuiseb Minerals Consulting
Richard Poulin, Université Laval
Vincent Blais, Université Laval


Non-equity project participants, such as creditors and the host government, have an important effect on the attractiveness of investing in natural resource projects.  An obvious cause of this effect is through the distribution of a portion of project cash flows as taxes, mineral royalties, and interest payments.  Non-equity participants also influence project value in a less direct manner through non-monetary contract terms that are intended to protect their interests.  Unfortunately, it is difficult to quantitatively assess the impact of such terms on the distribution of project value so that equity owners, government officials, and project financiers are left with qualitative or even rhetorical analysis to negotiate the terms of their participation.

In this paper, we use the real option valuation method to look at the effect of construction (completion) guarantees on project attractiveness when there is mineral price and foreign exchange rate uncertainty.  Construction guarantees are used by project financiers and some host countries as one method of ensuring that project development is completed instead of being suspended in the event of downside outcomes such as low mineral prices or extreme foreign exchange rate movements.  We show that these guarantees can result in a direct reduction of value in the equity owner’s claim to project cash flows that is not accounted for by conventional discounted cash flow valuation methods.  There are good reasons for project creditors and host governments to desire construction guarantees such as protecting downside risk exposure and ensuring economic development.  However, it is equally important for the mining company, project financiers, and the host country to understand the full implications that non-monetary contractual terms have on mining investment.


12:00 - 1:30 Luncheon

Keynote Address
Alexander Triantis
, University of Maryland

Dr. Triantis is Associate Professor of Finance at the Robert H. Smith School of Business at the University of Maryland. Previously he was a member of the finance faculties at the MIT Sloan School of Management (as a visiting scholar) and the University of Wisconsin. He received his Ph.D. from Stanford University in 1988. He is currently an Editor of Financial Management, an Associate Editor of Management Science, and an Advisory Board member of the Journal of Applied Corporate Finance.

Professor Triantis has published numerous articles on the topic of real options in the areas of finance, economics, law, management science and real estate. He has made important contributions on a range of topics, including the value of flexibility, the design of sequential and parallel investment strategies, the interaction between dynamic financing and investment policies, and the design of securities and contracts.

On the practitioner side, Dr. Triantis has been an advisor to several multinational corporations and consulting firms, as well as to U.S. Government departments and multilateral agencies. His role in helping companies adopt real options valuation tools has been cited in business publications such as Business Week, Business Finance Magazine and CFO Europe.


1:30 - 3:00 Valuing Power and Energy
Chairperson: Stathis Tompaidis
, University of Texas, Austin and ITAM, Mexico


Gas Fired Power Plants: Investment Timing, Operating Flexibility and Abandonment
Fleten, Norwegian University of Science and Technology
Erkka Näsäkkälä, Helsinki University of Technology


Many firms are considering investment in gas fired power plants. We consider a firm holding a license, i.e. an option, to build a gas fired power plant. The operating cash flows from the plant depend on the spark spread, defined as the difference between the unit price of electricity and cost of gas. The plant produces electricity when the spark spread exceeds emission costs. Otherwise the plant is ramped down and held idle. The owner has also an option to abandon the plant and realize the salvage value of the equipment. We compute optimal entry and exit threshold values for the spark spread. Also the effects of emission costs on the value of installing CO2 capture technology are analyzed.


Valuation and Optimal Interruption for Interruptible Electricity Contracts
Baldick, University of Texas at Austin
Sergey Kolos, University of Texas at Austin
Stathis Tompaidis, University of Texas at Austin and ITAM, Mexico


We consider interruptible electricity contracts issued by a distributor of electricity, that allow for interruptions to electric service in exchange for either an overall reduction in the price of electricity delivered, or for financial compensation at the time of interruption. We introduce an equilibrium model to determine electricity prices, based on stochastic models of supply and demand. In the context of this model we quantify the value of interruptible contracts and describe the optimal interruption strategy. Our numerical results indicate that, in a competitive market, interruptible contracts can alleviate supply problems associated with spikes of demand.


Fuel Cell Power Production in Shipping
Sigbjørn Sødal
, Agder University College, Norway


The paper discusses some main economic characteristics of fuel cell power production technology applied to shipping. Whenever competitive fuel cell systems enter the market, they are likely to have higher capital costs and lower operating costs than systems based on traditional combustion technology. Implications of the difference are investigated with respect to investment flexibility by the use of a real options model of ship investment, lay-up and scrapping decisions under freight rate uncertainty. A higher capital share of total expected costs can represent a significant opportunity cost in uncertain markets. The paper highlights the significance of accounting properly for value of flexibility prior to investment in new technology.


3:00 - 3:30 Afternoon Coffee Break


3:30 - 5:00 Valuing Infrastructure and Network Investments
Chairperson: Mark Jeffery
, Northwestern University


Real Options and Enterprise Technology Project Selection and Deployment Strategies
Mark Jeffery
, Northwestern University
Sandeep Shah, Northwestern University
Robert Sweeney, Wright State University


The reality of most IT departments is that capital is limited, or rationed, so that positive net present value (NPV) projects are not always funded. In the present work we examine enterprise technology projects that have a positive traditional NPV. Incorporating real option value enables management to more objectively compare and rank projects in a capital rationed information technology portfolio management process, and decide upon the optimal deployment strategy for the project. The present work examines different phase-wise deployment strategies for large enterprise technology projects and incorporates real options into the decision making framework. We focus specifically on multi-stage options embedded in enterprise data warehousing (EDW) projects. We also examine the lattice granularity necessary so that discrete time option valuation models more accurately describe large enterprise projects. We show that the single-step binomial lattice model significantly undervalues real options in large enterprise wide technology projects, and that a multi-step binomial model more accurately calculates the option value. We compare different deployment strategies with different underlying NPVs and volatilities. The results show that the traditional NPV of a project combined with additional real option premiums can provide important insight into the selection and deployment strategy for a project. Our results are generalizable to a large class of IT investment decisions where managers may consider single-phase versus multi-phase deployment in the presence of project risk.


Government Supports as Bundle of Real Options in Build-Operate-Transfer Highways Projects
Santi Charoenpornpattana
, University of Tokyo
Takayuki Minato, University of Tokyo
Shunsuke Nakahama, University of Tokyo


Recently government of many countries have adopted plan to encourage private investment on infrastructure undertaken normally by public sector. These infrastructures include highway, expressway, airport, power generation, water supply, and so on. Build-Operate-Transfer (BOT) scheme is widely employed in private financing of public infrastructure. BOT project normally involves dealing with many parties, huge amount of budget, long period of time, and many uncontrollable factors. These features make the BOT project very risky. Important risks include development risk, completion risk, cost increase risk, performance risk, operation risk, political risk, environmental risk, credit risk, and market risk. As a private financing scheme, BOT does not imply that private sector undertaking project must assume all the project risks. On the contrary, success of this scheme depends very much on reasonable supports or risk sharing from the government side.

The main focus of this paper is government supports in highway BOT project. In BOT highway project, government normally provides supports which mitigating financial-related risks such as market risk, because this kind of support has direct impact on project. Examples of such supports are direct financial subsidy, demand guarantee, revenue sharing, extension of concession period, and shadow tolls. However, the designs of such supports are somehow subjective, and irrational. Subjectivity is the result of lacking of quantitative method for evaluation. Irrationality comes from shortfalls of the current evaluation method.

The Real Options approach is proposed as a method for design and formulation of government supports. The main point is that government support can be taken as "Bundle of Options" from government given to private investor. In this paper, design and formulation of the Options-like government supports in BOT projects based on Real Options theory are explored.

Keywords: Real Options, Bundle of Options, Build-Operate-Transfer, Highway, Risks, Government supports, Minimum traffic guarantee, Shadow tolls system


Wireless Network Capacity Investment
Yann d'Halluin
, University of Waterloo
Peter Forsyth, University of Waterloo
Kenneth Vetzal, University of Waterloo


This paper applies modern financial option valuation methods to the problem of new wireless network capacity investment decision timing. In particular, given a cluster of base stations (with a certain traffic capacity per base station), we determine when it is optimal to increase capacity for each of the base stations contained in the cluster. We express this in terms of the fraction of total cluster capacity in use, i.e. we calculate the optimal time to upgrade in terms of the ratio of observed usage to existing capacity. We study the optimal decision problem of adding new capacity in the presence of stochasticwireless traffic for services. We develop a four factor algorithm that captures all of the constraints of wireless network management, based on a real options formulation. We study the upgrade decision for different upgrade decision intervals (e.g. monthly, quarterly, etc.), and we investigate the effect of a safety level (i.e. the maximum allowed capacity used in practice on a daily basis---which differs from the theoretical maximum).


Using Real Options to Determine Optimal Network Access Price
Ephraim Clark
, Middlesex University
Joshi Easaw, University of Bath, UK


As final goods markets have increasingly been liberalised, regulators have focused on network provision. Facilitating a liberalised final goods market with intense competition essentially requires an adequate and efficient network provision. Using standard techniques borrowed from the literature on option pricing and investment under uncertainty, the present paper introduces the role of dynamic network investment decisions with uncertainty and competition in the final goods market in the determination of the optimal access price. We show that the optimal access price can be evaluated as the certainty equivalent of the risky cash flows given up by the incumbent. This price also accounts for the entrant's option to time his entry and, thereby, does not give him undue advantage with respect to the incumbent and other entrants operating the final goods market. JEL Classification: L51, D81 Keywords: Network Access Pricing, Real Options, Investment under Uncertainty.


Track II

8:30 - 10:00 Competition and Strategy
Chairperson: Helen Weeds
, Lexecon Ltd. and University of Cambridge


Real Options and Strategy
Helen Weeds
, Lexecon Ltd. and University of Cambridge
Onno Lint, University of Leuven

This paper is still in progress, so the above link directs you to a related paper by Robin Mason and Helen Weeds.


Optimal Project Rejection and New Firm Start-ups
Cassiman, IESE Business School, Spain
Masako Ueda, Universitiy of Wisconsin-Madison


Entrants typically appear to be more innovative than incumbent firms. Furthermore, these innovative ideas often originate with established firms in the industry. Therefore, the established firm and the start-up firm seem to select different types of projects. We claim that this is the consequence of their optimal project allocation mechanism which depends on their comparative advantage. The start-up firm may seem more "innovative" than the established firm because the comparative advantage of the start-up firm is to commercialize "innovative" projects, i.e. projects that do not fit with the established firms' existing assets. Our model integrates various facts found in the industrial organization literature about the entry rate, firm focus, firm growth, industry growth and innovation. We also obtain some counter intuitive results such that a reduction in the cost of start-ups may actually slow down start-ups and that the firm may voluntarily give away the property rights to the inventions discovered within the firm.


The Value and Timing of Shared Real Options with Random Maturity
P.J. Pereira
, University of Minho, Portugal
M.R. Armada, University of Minho, Portugal


In this paper we present an original model, with the purpose of determining the value and timing of an investment opportunity (IO) that is shared by several companies, in a competitive environment.

We assume that the market can accommodate a finite number of firms (N), which are assumed to enter the market stochastically. Accordingly, the IO matures with the last "admitted" company's entrance and, after that moment, the option to invest disappears. Since companies can invest anytime up to, but not including, the random maturity date, it's important to determine the optimal timing to invest, in this context.

We provide an example that shows the value and the optimal timing for investing for several situations. As expected, the value of the IO, and its trigger value for investing, decreases as the available "places" in the market decreases, or (and) as the probability of a competitor entrance increases.
The example also shows that the IO's value and the optimal timing tend to the value and to the optimal timing of a perpetual American option as N assumes higher values or (and) when the probability of a competitor entrance tends to zero.


Preemptive Patenting under Uncertainty and Asymmetric Information
Yaowen Hsu
, National Taiwan University
Bart Lambrecht, University of Cambridge


This paper examines the investment behaviour of an incumbent and a potential entrant that are competing for a patent with a stochastic payoff. We incorporate asymmetric information into the model by assuming that the challenger has complete information about the incumbent whereas the latter does not know the precise value of its opponent's investment costs. We find that even a small probability of being preempted gives the informationally disadvantaged firm an incentive to invest at the breakeven point where it is indifferent between investing and being preempted. By investing inefficiently early to protect its market share, the incumbent gives up not only its option to delay the investment, but also reduces the value of the firm by an amount that increases with the investment cost incurred and the potential loss of market share. The investment behaviour of the challenger is the same as under complete information, namely the challenger 'epsilon preempts' the incumbent, if optimal to do so.


10:00 - 10:30 Morning Coffee Break


10:30 - 12:00 Competition and Games
Chairperson: Marcel Boyer
, Université de Montréal and CIRANO


Continuous-Time Option Games: Review of Models and Extensions
Marco Antonio Guimarães Dias
, PUC-Rio and Petrobras
José Paulo Teixeira, PUC-Rio


The theory of option-games being the combination of two successful, namely real options and game theory, has a great potential to applications in many real situations. Although the option games literature is very recent, it has been experimenting a fast growth in the last five years. It considers besides the key factors for investment decisions, such as the uncertainties, flexibility, and timing, the effect of competition with the possible strategies for each firm, in the same model. This paper reviews a selected literature on continuous-time models of option games and provides some new insights and extensions. Among others, we analyze models of duopoly under uncertainty - both symmetrical and asymmetrical, oligopoly under uncertainty, war of attrition and other models of positive externalities, and models with either incomplete or asymmetric information. We discuss concepts like the preemption, non-binding collusion, situations that mixed strategies are necessary, secondary equilibrium, etc. We summarize solution methods using concepts like the optimality of myopic behavior, and change in demand in order to solve oligopoly as an artificial perfect competitive market. In addition, we show that there are two equivalent ways to calculate both leader and follower values in duopoly under uncertainty models. We also extend the Joaquin & Buttler model by considering mixed strategies in asymmetric duopoly and the value of option to become leader. Three differen! t demand functions are considered. The paper also discusses the current option-games models limitations and suggestions for future research.


Competition Games in Duopoly Settings
Paxson, Manchester Business School
Helena Pinto, Manchester Business School


This paper presents two different real options models, with two stochastic factors considering strategic interactions. In the first model the profits per unit and the number of units follow two different stochastic paths and, in the second model the returns and the investment cost pursue different paths. For both models we analyse dissimilar games considering that the roles of the players are pre-assigned and also exogenous to the models, always assuming that the first mover has a competitive advantage over the second mover. Closed form solutions are obtained for the value functions of the first and second mover and for its trigger functions, except for the trigger of the first mover in pre-emptive environments. The paper analyses the effect of returns, investment cost and uncertainty on the models. Standard results do not always hold: uncertainty can delay the adoption of the first mover. Although pre-emption affects the leader's trigger it does not seem to influence the entry point of the follower.


Real Options, Preemption, and the Dynamics of Industry Investments
Marcel Boyer
, CIRANO, Université de Montreal
Pierre Lasserre, CIRANO, Université du Québec à Montréal
Thomas Mariotti, Université de Toulouse


Although most analyses of the preemption phenomenon have focused on environments in which each firm can make at most one indivisible investment, long-term competition per se does not rule out rent dissipation on new investments. In this paper, in order to assess the robustness of this result, and more generally to assess strategic behavior in long-run imperfect competition, we study the development of a duopoly industry in a continuous-time real-options model of capacity investment. Our methodology allows the evaluation of investment options and exercise rules in a strategic setup. We consider two alternative short-run competitive setups: Cournot competition and Bertrand competition. Under short run Cournot competition, firms choose output subject to their capacity. In the long run, they must decide what capacity to hold, given that demand can change unpredictably because of random aggregate shocks. In the initial industry development phase, firms attempt to preempt each other, so that the first industry investment occurs earlier than socially optimal and the first entrant takes more risk than socially optimal. While capacity units are costly, indivisible, durable, and big relative to market size, early entry cannot secure a first-mover advantage, so that both firms are active beyond some level of market development. Once both firms hold capacity, tacit collusion, taking the form of postponed capacity investment, may occur in Markov Perfect Equilibrium. Volatility and the expected speed of market development play a crucial role in the determination of competitive behavior: we show that a tacit-collusion equilibrium is certain to exist when market growth is highly volatile and/or very fast.

Bertrand competition reflects more adequately situations where the market is of finite size, and the willingness to pay is driven by stochastic taste shocks. In the short run, firms compete in prices given their existing capacity. In the long run, firms make irreversible acquisitions of indivisible units of capacity at a constant fixed cost. Our focus is again the timing of investments in a Markov perfect equilibrium of the game. Different patterns of equilibria may arise, depending on the importance of the real option effect. If the average growth rate of the market is close to the risk free rate, or if the volatility of demand shocks is high, no dissipation of rents occurs in equilibrium, despite instantaneous Bertrand competition. If these conditions do not hold, the equilibrium investment timing is suboptimal, and the firms' long-run capacities may depend on the initial market conditions. Our conclusions contrast sharply with standard rent dissipation results.

Key words: Real options; Option value; Duopoly; Preemption; Cournot; Bertrand; Collusion; Capacity; Industry growth; Volatility; Risk.

J.E.L. classification: C73, D43, D92; L13.


12:00 - 1:30 Luncheon

Keynote Address

Alexander Triantis, University of Maryland

Dr. Triantis is Associate Professor of Finance at the Robert H. Smith School of Business at the University of Maryland. Previously he was a member of the finance faculties at the MIT Sloan School of Management (as a visiting scholar) and the University of Wisconsin. He received his Ph.D. from Stanford University in 1988. He is currently an Editor of Financial Management, an Associate Editor of Management Science, and an Advisory Board member of the Journal of Applied Corporate Finance.

Professor Triantis has published numerous articles on the topic of real options in the areas of finance, economics, law, management science and real estate. He has made important contributions on a range of topics, including the value of flexibility, the design of sequential and parallel investment strategies, the interaction between dynamic financing and investment policies, and the design of securities and contracts.

On the practitioner side, Dr. Triantis has been an advisor to several multinational corporations and consulting firms, as well as to U.S. Government departments and multilateral agencies. His role in helping companies adopt real options valuation tools has been cited in business publications such as Business Week, Business Finance Magazine and CFO Europe.


1:30 - 3:00 Buyer-Seller Relationships and Supply Contracts
Chairperson: Bardia Kamrad
, Georgetown University


Asymmetric Buyer-Seller Relationships and Real Switching Options
Ellen Römer
, University of Paderborn, Germany


Industrial buyer-seller relationships are frequently characterized by the fact that the seller and/or the buyer have to dedicate specific up-front investments to the relationship. Marketing research analyzes these relationships on the basis of Transaction Cost Economics (TCE). TCE highlights the risk of hold-up which arises after specific investments are dedicated. However, exogenous uncertainties are largely neglected in TCE. Therefore, the aim of this paper is to analyze the effects of both hold-up and exogenous uncertainty on the value of customers in buyer-seller relationships. From the perspective of a supplier, the value of her customers is modeled by a dynamic programming approach. It is shown how different contracting scenarios affect hold-up and the value of an option to switch customers. A numerical analysis illustrates the analytical findings.


Strategic Relationships between Buyers and Sellers under Uncertainty
Milind Shrikhande
, Georgia State University
Ajay Subramanian, Georgia Tech
Nagesh Murthy, Georgia Tech


This paper proposes and investigates a theoretical model to analyze the real switching options that a firm with multiple economic agents holds and the corresponding implications for competitive equilibria between the firm and the agents. Although our model is generally applicable in several different economic scenarios, for expositional simplicity we consider the specific situation where the economic agents are suppliers of the firm. We begin by considering the optimal policy problem for the firm where it may face different exogenously specified relationship specific fixed costs and random variable costs vis-à-vis each supplier and its goal is to dynamically choose a supplier over time so as to maximize its expected discounted cash flows. At any instant of time, the firm therefore holds compound real options of either entering the market with a particular supplier, switching to another supplier or exiting the market. In the process of deriving the optimal dynamic policies for the firm,the paper specifically investigates the switching option of the firm, i.e. the option of the firm to switch between suppliers. In the case where the firm has two suppliers, we derive necessary and sufficient conditions on the fixed and variable cost structures of the firm vis-à-vis the suppliers for the switching option of the firm to have strictly positive value. These conditions have important implications for the firm's suppliers since either one of the two suppliers captures the market if these conditions do not hold. In other words, they represent necessary and sufficient conditions for each supplier to have positive expected revenue in any competitive equilibrium between the suppliers and the firm. We illustrate our analytical results through several numerical simulations.

Next, we investigate the general competitive equilibrium problem between the firm and its suppliers when both suppliers are in the same foreign country (or, more generally, in two countries with perfectly correlated or pegged currencies). The prices quoted by the suppliers and, therefore, the variable costs of the firm are now determined endogenously in equilibrium where the suppliers and the firm respond rationally and optimally to each other's policies. We use the insights from the firm's optimal policy problem to develop and implement a numerical procedure to solve the competitive equilibrium problem. We derive competitive equilibria between the firm and its suppliers for several different values of underlying parameters that illustrate the impact of competition in global markets.


Profit Sharing and Adjustment Options in Supply Contracts
Bardia Kamrad
, Georgetown University, McDonough School of Business
Akhtar Siddique, Office of the Comptroller of the Currency


A common theme in the studies of flexible supply contracts has been the producer's profit maximization problem without regard for the suppliers'; reactions to the producer's operating policies. However, suppliers do react and protect their downside against producer's operating policies by revising their strategies in a manner consistent with their profit maximization objectives. This fact motivates our work. Using a real options (contingent claims) approach, we analyze and value supply contracts in a setting characterized by exchange rate uncertainty, supplier-switching options, order quantity flexibility, profit sharing, and supplier reaction-options. We also use basic diversification concepts, from portfolio theory, to provide a unique framework for risk reduction. Given this set up, we explicitly model how flexibility can be mutually beneficial to the producer and his suppliers. We also analyze what induces the producer and the suppliers to accept flexibility in their contracts.


3:00 - 3:30 Afternoon Coffee Break


3:30 - 5:00 Valuing Manufacturing & Production Options
Chairperson: Apostolos Burnetas
, Case Western Reserve University


Effects of Correlated Defaults in Supply Chains
Volodymyr Babich
, Case Western Reserve University
Apostolos Burnetas, Case Western Reserve University
Peter Ritchken, Case Western Reserve University


We study the effects of credit risk in a supply chain where one retailer deals with competing risky suppliers who may default during their production lead-times. The suppliers, who compete for business with the retailer by establishing wholesale prices, are leaders in a Stackelberg game with the retailer. The retailer, facing uncertain future demand, chooses order quantities while weighing the benefits of procuring from the cheapest supplier against the advantages of reducing credit risk through diversification. Although, in general, the timing of the retailer-to-suppliers payments is important, we identify a family of wholesale pricing policies for which, in equilibrium, the suppliers and the retailer are indifferent between up-front and on-delivery payment schedules. Our analysis reveals that the equilibrium firms' profits decline as default risk increases. Furthermore, the decline rates for firms in different echelons of the supply chain depend on the shape of the demand distribution. If the wholesale prices were fixed, the retailer would benefit from the decreasing correlation of the defaults. However, if prices are endogenous to the model, the decreasing defaults' correlation alters the nature of the competition among the suppliers and lowers the equilibrium wholesale prices. We show that, in equilibrium, the retailer prefers suppliers with positively correlated default events. In contrast, the suppliers and the supply chain prefer defaults that are negatively correlated.


Market and Process Risks in Production Opportunities: Demand and Yield Uncertainty
Bardia Kamrad
, Georgetown University
Keith Ord, Georgetown University


By adopting a real options framework, we develop and analyze a production based valuation model that jointly incorporates process and market risks. Given this setting, techniques of contingent claims analysis and stochastic control theory are employed to obtain value maximizing operating policies in a constrained capacity environment. In our analysis, adjustments to operating policies are analogously modeled as a sequence of complex (real) options whose optimal exercise maximizes their inherent flexibility value.


A Real Option Valuation of Delivery Time Uncertainty
N. Takezawa
, International University of Japan


We attempt to value the delivery time uncertainty related to the disruption of the production line due to breakdowns in a consumer electronic production line. In this type of manufacturing environment, the steady state production activity will have little option value attached to the delivery time, but the major source of uncertainty often originates from machine breakdowns. In this paper, we decompose the delivery time uncertainty into two parts, the direct impact from the breakdown and the secondary effect due to the recovery process. The second factor is examined and interpreted as the workforces’ effort to recover from a machine breakdown.

Key Words: Real Option, Outsourcing, Production, Delivery Time, Mean Reversion




7:30 - 8:30 Continental Breakfast

Track I


8:30 - 10:00 Optimal Investment
Chairperson: Jean-Daniel Saphores
, University of California Irvine


The Optimal Value of Waiting to Invest with Learning
Herve Roche
, Instituto Tecnologico Autonomo de Mexico


The goal of this paper is to study irreversible investment decisions under incomplete information when the investor has an active role and can increase her knowledge about the type of the project she wants to undertake. In their seminal article ''The Value of Waiting to Invest'', McDonald and Siegel (1986) highlight the option value of waiting in the case of an irreversible investment. In their paper, uncertainty is modeled by (and reduced to) a shock affecting the future benefits of investing. Irreversibility and the possibility of delay generate a range of inaction and the investment decision does not occur as soon as the NPV of the project is positive but instead, the investor requires a wedge between the value of the project that triggers investment and the cost of investing. In this article, we incorporate some incomplete information about the characteristics of the project into the classical real option framework. Applications include investments in new and unfamiliar markets (joint ventures), research and development, and new start-up companies. Typically, the expected growth rate of the project is known to be either low or high. Waiting and observing the realizations of the value of the project provide information to the investor who can update her beliefs about the true value of the expected return. Moreover, the investor can purchase some additional information, which allows her to control the learning speed of her beliefs. We prove the existence of a solution to the optimal control program and derive analytical properties for the option value and the optimal trigger investment frontier. Investor's beliefs follow a martingale and the optimal investment trigger depends on the degree of optimism. We propose an original algorithm to solve the ! non-linear Bellman equation with a free boundary to be determined. The optimal amount of information purchased is found to be increasing in the project payoffs and the variance of beliefs, but decreasing in the project volatility. Overall, the opportunity to purchase information enhances the option value of waiting to invest, thus delays investment.


Barriers and Optimal Investment Rules
Jean-Daniel Saphores
, University of California Irvine


This paper revisits the simplest stochastic investment decision: when to incur a sunk cost in exchange for a random payoff. It shows that the standard real options approach typically yields incorrect decision rules except for reflecting or unattracting barriers. Optimal investment rules are derived for different barriers and illustrated for common stochastic processes. An explicit solution for the perpetual call option with a lower absorbing barrier is also obtained; it shows that the standard perpetual call option overestimates the corresponding investment threshold when uncertainty is high enough. These results have implications for stochastic investment problems in continuous time.


Is the Myopic Investor Right? Numerical Evidence for Systematic Overestimation of Investment Reluctance for Real Options
Musshoff, Humboldt University Berlin
Norbert Hirschauer, Humboldt University Berlin
Alfons Balmann, Institute of Agricultural Development in Central and Eastern Europe (IAMO)
Martin Odening, Humboldt University Berlin


Empirical applications of real options models in competitive environments implicitly exploit the optimality of myopic planning. In a seminal paper Leahy (1993) shows that the optimal investment strategy of a myopic planner, who ignores market entries and exits of competitors as well as the resulting price effects, also constitutes a market equilibrium under rather general conditions. As a result, the calculation of optimal investment strategies is simplified considerably because competition does not have to be taken into account. In this paper, however, we demonstrate that myopic planning may lead to non-optimal investment strategies. This is due to the fact that it is difficult, or even impossible, to specify the correct or equivalent price process for the myopic investor using real world data. The myopic investor acts on the assumption of an unregulated (exogenous) price process. But what we observe in the real (competitive) world is indeed the outcome of a regulated (endogenous) price process. Hence, an estimation of parameters which is based on the unregulated form of stochastic process is inconsistent. This misconception, whose outcome we call 'competitive bias', has been widely ignored in the literature. Our paper quantifies this bias, analyses its determinants and shows the outcome of alternative estimation procedures which could be used to get around it. It turns out that due to the 'competitive bias' the widely acknowledged 'reluctance to invest' is over-estimated. The suitability of alternative estimation methods depends on their respective specifications.

Keywords: investment, uncertainty, competition, myopic planning


10:00 - 10:30 Morning Coffee Break


10:30 - 12:00 Valuing Levered Equity, Debt and Capital Structure Interactions
Chairperson: Grzegorz Pawlina
, Tillburg University


Real Options, Capital Structure, and Taxes
Andrea Gamba
, University of Verona, Italy
Carmen Aranda Leon, University of Navarra, Spain
Gordon A. Sick, University of Calgary, Canada


This paper presents a valuation approach for real options when the capital structure of the underlying project/firm is levered, assuming that the goal is the maximization of total firm/project value (i.e., under a first-best investment policy). We analyze also the effect of different financing schemes on the value of the real option and on the exercise policy. The main finding of this work is that a higher leverage reduce the time-value of the option to delay investment and increases the probability of exercising the options.


Underinvestment, Capital Structure and Strategic Debt Restructuring
Grzegorz Pawlina
, Tilburg University, The Netherlands


In this paper the investment and liquidation policy of a levered firm is analyzed. The possibility of renegotiating the original debt contract is included. It is shown that the shareholders' option to restructure the outstanding debt exacerbates Myers' (1977) underinvestment problem. This result is due to a higher wealth transfer from the shareholders to the creditors occurring upon investment when the option to renegotiate is present. The problem can be eliminated only when all the bargaining power is given to the creditors. In such a case, the renegotiation commences at the shareholders' bankruptcy trigger and no additional wealth transfer occurs. Moreover, it is shown the liquidation policy under partial debt financing differs from the optimal policy when the firm is all-equity financed. Even after removing the effects of the tax shield by excluding taxes, it holds that the liquidation policy is affected by the second-best investment policy, thus it occurs inefficiently early. Finally, it is shown that the presence of a positive NPV investment opportunity increases the likelihood of a strategic default when the bargaining power of shareholders is high.


The Valuation of Corporate Debt with Default Risk
Hassan Naqvi
, London School of Economics


This article values equity and corporate debt by taking into account the fact that in practice the default point differs from the liquidation point and that it might be in the creditors' interest to delay liquidation. The article develops a continuous time asset pricing model of debt restructuring which explicitly considers the inalienability of human capital. The study finds that even though in general the creditors will not liquidate the firm on the incidence of default, but nevertheless would liquidate the firm prematurely relative to the first best threshold. This agency problem leads to the breakdown of the capital structure irrelevance result. Abstract:


Carrots or Sticks? Optimal Compensation for Firm Managers
Ajay Subramanian
, Georgia Institute of Technology


We investigate the existence of and explicitly characterize compensation structures that eliminate agency conflicts between a leveraged firm (or its shareholders) and the manager due to managerial asset substitution within a continuous time framework. The manager may dynamically switch between two strategies with different risks and expected returns after debt is in place. We show that when the strategies satisfy a specific condition that (roughly) ensures that the difference in their drifts is not large compared with the difference in their volatilities, a periodic compensation structure that completely aligns the manager’s interests with those of the firm (or its shareholders) is one where the manager’s payoff is proportional to the firm’s operating cash flows, but subject to a floor and a ceiling. This result explains the prevalence of compensation schemes where firm managers obtain shares of firm profits subject to floors and ceilings apart from the usual components of cash,stock, and options. We also investigate conditions under which convex and concave compensation structures are optimal. We show that a concave compensation structure where the manager obtains a proportion of firm cash flows subject to a ceiling is optimal when the higher volatility strategy also has a higher expected return. On the other hand, a convex compensation structure where the manager obtains a proportion of firm cash flows subject to a floor is optimal when the higher volatility strategy has a lower expected return. Our theoretical analysis therefore offers insights into features of compensation contracts that mitigate agency conflicts due to managerial asset substitution.

Key Words: Optimal Compensation, Asset Substitution, Agency Costs


Track II

8:30 - 10:00 Economic Models of Real Options Valuation
Chairperson: Hassan Naqvi
, London School of Economics


Investment and Value of a Firm Facing Uncertainty, Adjustment Cost, Information Costs and Irreversibility
Mondher Bellalah
, University of Cergy and Paris-Dauphine


Following the analysis in Abel and Eberly (1997), I derive closed-form solutions for the investment and value of a competitive firm with a constan treturns- to-scale production function and convex costs of adjustment. The analysis concerns reversible and irreversible investments under incomplete information. Optimal investment seems to be a non-decreasing function of q, the shadow value of capital. This depends also on the magnitude of shadow costs of incomplete information.


On the Real Option Value of Scientific Uncertainty for Public Policies
Justus Wesseler
, Wageningen University, Netherlands


In this paper scientific uncertainty is defined as the impossibility to choose the correct stochastic process for the value of a public policy. The real option value of waiting under scientific uncertainty is derived using the difference between the geometric Brownian motion and the mean reverting process by applying contingent claim analysis. The results are compared with those generated by either using a geometric Brownian motion or a mean-reverting process only. The results show that scientific uncertainty is less important than one would expect at first hand. The small effect of scientific uncertainty adds confidence to the use of a geometric Brownian motion for the kind of public policy decisions discussed in this paper. The paper contributes to the suggestion made by scientists to analyze the sensitivity public policy valuations, provides insights about the magnitude of error that can be made by choosing the wrong process, provides a solution to the problem and highlights the implication for public policy decision making.


Real Options Effects on Employment: Does Exchange Rate Uncertainty Matter for Aggregation?
Ansgar Belke
, University of Hohenheim, Germany
Matthias Göcke, University of Münster, Germany


In a baseline micro model a band of inaction due to hiring- and firing-costs is widened by option value effects of exchange rate uncertainty. Based on this micro foundation an aggregation approach is presented. Under uncertainty, intervals of weak response to exchange rate reversals are introduced on the macro-level. 'Spurts' in new employment or firing may occur after an initially weak response. Since these mechanisms may apply to other investment cases where the aggregation of microeconomic real options effects under uncertainty are relevant, they may even be of a more general interest.


Quota Utilization under Voluntary Export Restraints: The Case of Textile and Clothing
Jihe Song
, University of Wales, Aberystwyth, UK
Shumei Gao, Heriot-Watt University, UK


A large part of international trade today is governed by quantitative restrictions. In this paper, we apply the real options framework to the analysis of trade policy instruments. The partocular instrument studied in this paper is the so-called "Voluntary Export Restraints" (VERs). We extend the early analysis of Anderson (1986), Eldor and Marcus (1988) to the valuation and exercise of export quotas under VERs. Of particular interest is quota utilisation, which is modeled as an option exercise problem. We also present extensive evidence on quota utilisation rates for textile and clothing export from East Asian countries to the European markets in the 1980s. While the evidence in general supports the model, the data presents more challenges for real options modeling.


10:00 - 10:30 Morning Coffee Break


10:30 - 12:00 Theoretical Issues
Chairperson: Ajay Subramanian
, Georgia Institute of Technology


Market Entry, Pricing Decisions and Options Contracts
Alison Dean
, University of Kent, UK
Charles Baden-Fuller, City University, UK


This paper bridges the literature on real options in strategy with that on financial options. It uses insights from both literatures to show how the use of options contracts can encourage innovators to enter markets by mitigating the effects of uncertainty and permitting the capture of greater value from innovation. The dilemma facing a firm trying to secure the successful launch of its innovation is how to set price to achieve market penetration yet still receive an adequate return. The traditional view is that the low price necessary for penetration may yield such poor returns that the innovator is dissuaded from launch. This problem is exacerbated when the innovator is an entrant and faces retaliatory reactions from incumbents. We explore how financial options can mitigate these effects and recapture the "lost" added value. Using financial options can encourage commitment, overcome delay in launch and allow innovators to capture value quickly. Finally, we explore s! ome of the impediments to executing our ideas, discuss when they might be useful to managers and suggest ways in which they can be tested empirically.


Controlling Cash Flow at Risk with Real Options with Applications in Shipping
Giuseppe Alesii
, Universita' de L'Aquila, Italy


Cash flow at risk (CFaR) can be controlled using real options. In this normative paper, we derive numerically in a univariate discrete time model, extension of (Kulatilaka, 1988), the expanded NPV of an industrial investment and, simultaneously, state variable thresholds to optimally exercise real options for the whole life of the project. In this framework, we model total variability in expanded NPV using a Markov chain Montecarlo method. A number of original results are derived for an all equity financed firm. Cash Flow distribution and CFaR is derived for each epoch in the life of the project. A VaR for the expanded NPV at time 0 is derived. These new methods have been applied to two case studies in shipping finance, namely a very large crude carrier and a Panamax.


Real Options Lesson: Learn Before You Act
Spiros Martzoukos
, University of Cyprus
Nicos Kousis, University of Cyprus
Lenos Trigeorgis, University of Cyprus


We develop a model of strategic interactions that incorporates the ability of the firm to actively enhance the value of a new technology or product before final development through R&D actions that improve quality or add new features. We encompass optional, costly, and interacting (impulse type control) actions with random outcome in a semi-American real options investment problem. Before though the firm commits to such costly actions, it engages in acts of (filtering like) learning about the quality or attributes of products or technologies, the potential market share of products, the quantity of natural reserves, etc. This sequence of actions can be interpreted as similar to investment in marketing research, before the firms commits to an expensive advertising campaign; and to exploration about the existing standing of a product or process before commitment to enhance attributes and improve qualitative and quantitative characteristics. We numerically analyse optimal activation rules and calculate project values for the case of single or sequential actions. We allow the distributional characteristics of R&D (or marketing) actions and their cost structure to be affected by their sequence (path). This feature adds considerable complexity and computational difficulty, but it also allows the study of optimal timing of such actions, time to learn effects (lag in the impact of control), abandonment decisions for partial recovery of invested capital, and learning by doing effects (reduction in cost, enhancement of impact, etc.). Our results demonstrate the importance of active management and optimal R&D choice.

Return Characteristics of Strategic Options
Hans Haanappel, Erasmus University, Netherlands


In this study we develop implications for the return distribution of firms with embedded strategic growth options. In our model we integrate real option theory with a Cournot-Nash framework where two firms choose output levels endogenously and may have investment-timing differences. Simulations of the returns of the strategic growth option show that traditional option variables, such as the value of the project relative to the investment (i.e., moneyness of the growth option), the return interval relative to the period the project can be deferred (i.e., maturity), and uncertainty in demand for the product are significant determinants for the moments of the distribution of the option returns. In addition to these option variables, uncertain preemption may introduce discontinuities in the payoff of our model and consequently further enhance skewness and kurtosis. Investment-timing differences between competitors may even lead to bimodal return distributions, where the firm with a first-mover advantage has a high probability to generate high returns.


12:00 - 1:00 Panel Discussion: Current State, Challenges and Future Prospects
Moderator: Alex Triantis
, University of Maryland

Panelists Include:
Adam Borison (Sanford University)
Marcel Boyer (Université de Montréal and CIRANO)
Bardia Kamrad (Georgetown University)
Ted O'Leary (University of Manchester and University of Michigan)
Ajay Subramanian (Georgia Institute of Technology)
Lenos Trigeorgis (University of Cyprus and ROG)
Helen Weeds (Lexecon Ltd and University of Cambridge)


1:00 Closing Remarks: Conference Concludes

Thursday | Friday Track I | Friday Track II
Keynote Address | Saturday Track I | Saturday Track II

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