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Annual International Conference on Real Options: Theory Meets Practice

8th Annual International Conference

Montréal Canada, June 17-19, 2004

Abstracts and Links to Papers

Thursday | Friday | Saturday

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






Empirical Evidence


Case Applications & Public Policy


Panel Discussion (joint):
Valuation, Technology & Corporate Strategy


Networking Reception Sponsored by



Track I

Track II


Registration & Breakfast


President's Address



Strategic Decisions/Valuation



Competition and Strategy


Luncheon Address by
Michael J. Brennan


Valuing Power Investments

Competition and Games



Valuation Issues


Keynote Address by
Stewart C. Myers



Track I

Track II




Technology Investments

Theoretical Issues


Agency Issues


12:00 - 1:00

Panel Discussion:
Current State, Challenges and Future Prospects


Thursday 1:30 pm - 2:45 pm

Empirical Evidence
Chairperson: Jeffrey Reuer, U. of North Carolina - Chapel Hill

1:30 PM
Corporate Investment Decisions and the Value of Growth Options
Tony Tong, Ohio State U.
Jeffrey Reuer, U. of North Carolina - Chapel Hill

Recent applications of real options theory in strategy research have examined investment decisions framed as the purchase or exercise of particular options, but research has yet to offer direct evidence on whether firms actually capture option value from such investments. In this paper, we estimate the proportion of firm value accounted for by growth options and link the growth option value to corporate investments that have been commonly viewed as providing valuable growth options. The empirical analysis examines internal and external corporate development activities of a panel of 293 manufacturing firms during 1989-2000. The results indicate that investments in research and development and in joint ventures contribute to growth option value, and that investments in tangible capital and in acquisitions have no effect in general. Notably among equity joint ventures of various ownership levels, only minority joint ventures have significant effects.

1:55 PM
Investor Valuation of the Abandonment Option: Empirical Evidence from UK Divestitures
Ephraim Clark, Middlesex U.
Magid Gadad, Finance Institute of Tripoli
Patrick Rousseau, U. Aix-Marseille

This paper looks at divestitures by 144 UK firms listed on the LSE from 1985 to 1991 and investigates whether and how accurately investors price the firm's option to abandon assets in exchange for their exit value. Theory prices this real option as an American style put and the model we test includes the major features of the abandonment option literature: stochastic firm value (the underlying security), stochastic exit value (the strike price), intermediate cash flows and uncertain project life. It also includes random events that can short circuit the optimal timing of the divestiture and trigger abandonment prematurely. The empirical implications are that investors do price the abandonment option but that they price it imperfectly because the exit price is private information. We find that the effects of the timing factor are accurately priced. We also find weak evidence that the probability of forced premature abandonment figures in the option pricing.

Keywords: real options, abandonment, divestiture, premature abandonment, abnormal returns.

JEL Classification: G13, G33, G35, M41

2:20 PM
Empirical Testing of Real Options in the Hong Kong Residential Real Estate Market
Huimin Yao, U. Hong Kong
Frederik PRETORIUS, U. Hong Kong

Hong Kong has been using the leasehold system of land management rather than freehold since its colonial era. This system controlled and presently still controls uses of leased land through leasehold conditions, while new or renewed leases regulate land uses by zoning regulations functioning through statutory town planning, and with appropriate conditions incorporated in new leases. Many leases granted decades ago thus require formal modifications to lease conditions to formalize proposed changes in land use, or to realize the actual present economic value of the land, or to reflect the current market demands. From a real options analysis perspective, these land use conversions and analysis of real options associated therewith are significantly more complex than typical stylized land development real options encountered in academic literature and research. There is thus considerable interest in obtaining empirical evidence of the performance of real options valuation in land development applications, where options associated with land development rights are substantially constrained due to regulatory influences. The aim of this research is to outline major factors in operationalizing academic real options research for practical application in a particular land market with significant regulatory constraints, and then test two propositions derived from academic real options literature using actual residential real estate development projects in Hong Kong which require leasehold land conversion under statutory planning and zoning regulations as source of data. Typically past land use conversions in Hong Kong required developers to acquire raw or other redevelopable land through private negotiations with initial land lease owners and to wait for public provision of infrastructure and services, before applying for formal and legal conversion from a lower to higher land use. Our study concentrates on the period between when land is acquired and when actual construction of the development starts, and as becomes clear, the regulatory framework that governs land development significantly narrows typical real options as perceived in academic land development literature.

Thursday 3:15 pm - 4:30 pm

Case Applications and Public Policy
Chairperson: Jean-Daniel Saphores, U. California - Irvine

3:15 PM
Architectural Flexibility: A Case Study of the Option to Convert to Office Space
Lara Greden, MIT
Leon Glicksman, MIT

Corporate facility managers and real estate developers recognize the potential value in flexible spaces. Investments in architectural flexibility are currently guided by client intuition and refined by the architect's knowledge of specifications allowable within the realm of building codes and the applicable costs. More formal valuation of flexibility in architectural design would help inform rational levels of investment in the design process and resulting construction to address relevant uncertainties. This research addresses the assumptions needed to apply financial-type real options models to physical design questions, concluding that the governing uncertainty must be a market-based factor such as the price of rent. For a case study for a corporate campus, a model is developed to determine the option value to convert a space to office space. The date at which change occurs as well as the future prices of renting (the alternative to renovating) are stochastic variables. The model provides results in the following form: it is worth $C to invest in the design and construction of a space that can be renovated for $X. The results help decision-makers justify increased investment in designs that will cost less to renovate (i.e. are more flexible) in the future.

3:40 PM
Grandma or the Wolf?: Managing Human-Wildlife Conflict
Baishali Bakshi, U. California - Irvine
Jean-Daniel Saphores, U. California - Irvine

As wildlife habitats shrink, some species are pushed into extinction, while conflicts with others increase and cause significant economic damages. This paper proposes a simple real options framework to analyze wildlife management policies that account for ecological uncertainty and the risk of extinction. Our application to wolves provides an economic justification for their reintroduction and highlights the importance of existence value. Our sensitivity analysis shows that the optimal management policy depends on the growth rate, the volatility, and the minimum viable density of the wolf population, but little on damages, existence value, and the discount rate for the parameters considered.

4:05 PM
Private Investment in Biodiversity Conservation
Dagmar Mithoefer, U. of Hannover
Justus Wesseler, Wageningen U.
Hermann Waibel, U. of Hannover

In the 1990's, the World Agroforestry Centre (ICRAF) initiated a domestication programme of indigenous fruit trees (IFTs) in Southern Africa to increase farm-household income through farmer-led tree planting and thus conserve bio-diversity. From the farmer's point of view planting domesticated IFTs is an investment under uncertainty and irreversibility. As timing of planting is flexible, real options theory suggests that waiting to invest may be a profit maximising strategy. Applying the real option theory the critical value of an investment in planting IFTs is derived using contingent claim analysis. As previous studies on ex-ante assessments investments in agriculture have used dynamic optimisation, we use contingent claims and explicitly derive the risk adjusted rate of return from the Consumer Capital Asset Pricing Model by using the different sources of farm-household income. Our analysis investigates to what level
(1) fruit collection cost and/or
(2) the necessary technical change, i.e. breeding progress, have to rise that will render tree planting economical.
Results show a combination of technical change and decrease in resource abundance provides scope for farmer-led planting of domesticated IFTs and bio-diversity conservation. However, breeding progress must be significant for investment in tree planting to be economically attractive and thus to contribute towards on-farm preservation of the IFTs.

Keywords: biodiversity, CAPM, real option, R&D, technology adoption, Zimbabwe.

Thursday 5:00 - 6:00

Panel Discussion
Chairperson: Blake Johnson, Stanford University

Vladimir Antikarov, Monitor Group
Rainer Brosch,
Boston Consulting Group
Gil Eapen,
Decision Options LLC
Scott Matthews,
Boeing Corp.
Roger Vardan, ROG, ex General Motors

Thursday 6:30 pm - 8:00 pm

Networking Reception Sponsored by CIRANO & CIREQ and ROG

Friday 7:00 am - 7:45 am

Registration and Breakfast

Friday 7:45 am

Chairperson's Welcome
Chairperson: Marcel Boyer, U. Québec - Montréal, CIRANO & CIREQ

Friday 7:45 am - 8:20 am

President's Address
Chairperson: Lenos Trigeorgis, ROG & U. of Cyprus

Friday Track I 8:30 am - 10:10 am

Conceptual & Practical
Chairperson: James Alleman, U. of Colorado - Boulder & Columbia U.

8:30 AM
Real Options and the Theory of the Firm
Ellen Roemer, U. Paderborn & U Bradford

Real options analysis is a research field that spreads across different academic disciplines. In recent times, real options analysis is more and more advancing into the domain of strategic management. In this respect, it can be observed that an increasing number of papers is dealing with real options analysis in combination with organizational questions. In this paper, I investigate the organizational decision how real options should be aligned: by market coordination, by hierarchical coordination or by intermediate coordination. I explore to what extent real options analysis can support such organizational decisions. More precisely, the research question is how real options analysis can be contribute to determine whether real options should be organized out outside the firm, inside the firm or in intermediate forms of coordination. Therefore, I sketch the foundations of real options analysis and I briefly summarize Transaction Cost Economics as one approach to explain the boundaries and the existence of firms. Moreover, I compare the two approaches in order to demonstrate parallels and divergences as a basis for a discussion of real options and decisions of economic organization. Subsequently, I discuss different types of uncertainty along with different types of options. I point out how real options should be organized to maximize the value of the firm. The paper closes with some critical remarks and ideas for future research.

8:55 AM
Rules of Thumb in Real Options Analysis
Giuseppe Alesii, U. de L'Aquila, Italy

In this normative paper we derive payback period (PBP) and internal rate of return (IRR) in the presence of real options. In a Kulatilaka - Trigeorgis General Real Option Pricing Model, we derive the expected value of these two decision rules that corresponds to the expected NPV Bellman dynamic programming maximizing strategy in the presence of the options to wait, to mothball and to abandon. A number of original results are derived for an all equity financed firm. Expected PBP and IRR at time 0 are derived together with their distribution. These new methods are applied to a case study in shipping finance. Real options are shown to be value enhancing and shortfall decreasing also with respect to thumb rules: expected IRR is increased while expected PBP is decreased. Probabilities of earning negative returns are reduced together with those of not recovering initially invested capital. Our model gives a more intuitive insight into the dynamic optimal behavior which is endogenous to real options valuation models showing plainly how the representative agent would probably manage optimally her project. This would help to compare optimally dynamic behavior with current practice and to conclude whether real options are a simple pure academic abstraction or a realistic model.

9:20 AM
The Option to Sell a Real Asset and the Grace Rate Rule
Meir Fradkin, U. of North Texas

This paper explores an option to sell a real asset (a put option on a real asset), under general assumptions accepted in the literature about investment under uncertainty. First, general differential equation for the put option value is derived, and appropriate boundary conditions are spelled out. Next, a behavior of this real option value is examined, while looking at this value as a function of asset's parameters, such as volatility of cash flows, and a discount rate. Then, as an analog for the hurdle rate rule in case of investing in the real asset, the 'grace rate' rule is introduced as a proxy for the optimal selling (scrapping) decision. The finding is that, similarly to the hurdle rate rule, the 'grace rate' rule is robust enough, and may lead to a near optimal decision for a wide range of the project's parameters.

9:45 AM
An Investment Decision-Making Criterion Incorporating Real Options
James Alleman, U. of Colorado - Boulder & Columbia U.
Hirofumi Suto, NTT East, Tokyo, Japan
Paul Rappoport, Temple University, Philadelphia, PA, USA

This paper provides an investment decision-making criterion under uncertainty using real options methodology to evaluate if an investment should be made immediately, cautiously, deferred (wait-and-watch), or foregone. We develop a decision-making index d, which is equal to the expectation of net present value (NPV) normalized by its standard deviation. Under a lognormal assumption of the distribution of NPV discounted by risk-free rate, we find the break-even point at which the NPV equals the real option value (ROV): d = D* = 0.276. Using the absolute value of D*, one can make sophisticated decisions considering opportunity losses and costs of uncertainty. This new decision index, d, provides a criterion to make investment decisions under uncertainty. When making a decision, a manager only has to observe three parameters: expectation of future cash flow, its uncertainty as measured by its standard deviation, and the magnitude of investment. We discuss examples using this criterion and show its value. The criterion is particularly useful when NPV lies near zero or uncertainty is large.

Keywords: Real Options, Investment Decisions, Present Value, Project Valuation

Friday Track II 8:30 am - 10:10 am

Strategic Decisions/Valuation
Chairperson: Pierre Mella-Barral, London Business School

8:30 AM
Valuing a Start-Up Firm: Creative Destruction and Real Options
Cecilia Maya, U. EAFIT, Colombia

In this paper I propose a Creative Destruction - Real Options Approach (CD-ROA) to valuing start-ups when only technological uncertainty is present. I claim that is the case when a company takes part of a Creative Destruction process as described by Schumpeter (1942). This approach is able to explain the high prices investors pay for growth stocks and proves that it is not a case of overpricing but recognition of the large growth potential of firms which are part of highly innovative industries. I also perform a case study on the valuation of Gilead Sciences, Inc., using the CD-ROA.

8:55 AM
Valuing a Leveraged Buy-out
Francesco Baldi, U. of Rome III

The leveraged buy-out is a financial technique that consists in the acquisition of the majority of a firm by a group endowed with entrepreneurship, composed of private investors or institutional investors or merchant banks or by all three subjects together, mostly financed by debts, destined to be paid back using the financial resources produced by the firm itself in the form of Free Cash Flows from Operations or divestments of non-strategic activities as well as assets and shares as side guarantee to obtain the loan itself . The aims of the team of the buyers are two:
1)   valuate the target firm, that is fix the top price they are willing to pay to the vendor to buy the firm;
2)   examine the options of different nature that shareholders and management will have during the administration of the target firm and the interactions that, probably, will be established with each other in order to include them in the determination of the economic value.
These aims shall be reached considering that the problem to be faced may be divided into three steps:
a)    organize the Newco's financial structure getting the quantity of debt necessary to carry out the acquisition from banks and bondholders;
b)    pay back the contracted debts within the due date, avoiding insolvency;
c)    reorganize the target firm's structure in order to improve the business performance and to assure, if not to accelerate, the reimbursement of the debt by means of larger Free Cash Flows from Operations.
The paper is organized as follows. First, we describe the main characteristics of a leveraged buy-out structuring process as well as the traditional approach usually applied to perform the valuation of the target firm represented by the Adjusted Present Value pure method. Second, we propose a correction of the Adjusted Present Value method by means of an integrative use of the Real Option Approach. In particular, we identify two real options that may be considered inherent in a leveraged buy-out technique: a financial default option and an operating default option. The expansion of the firm value is accomplished relying on the common roots existing between the NPV analysis and the Discounted Cash Flow method. So it is possible to pass from a passive equity value to the equivalent expanded value and transform the valuation of the target firm from passive to dynamic through the merger, in the process of managerial choices and so, also in the valuation process, of real options. The result of the suggested integration is called Expanded Equity Value. Finally, a business case is reported in order to illustrate our reasonings.

9:20 AM
Knowhow Acquisition in the Formation and Duration of Joint Ventures
Pierre Mella-Barral, London Business School
Michel Habib, U. of Zurich

We analyze the role of knowhow acquisition in the formation and duration of joint ventures. Two parties become partners in a joint venture in order to benefit from each other's knowhow. Joint operations in the joint venture provide each party with the opportunity to acquire part or all of its partner's knowhow. A party's increased knowhow provides the impetus for the dissolution of the joint venture, as it decreases the need for the partner's knowhow. Dissolution takes the form of the buy out of one partner by the other. We characterize the conditions under which such dissolution takes place, identify the party that buys out its partner, determine the expected time to dissolution and various measures of uncertainty regarding that time, establish its comparative statics, and examine the implications of knowledge acquisition for the desirability of joint venture formation.

9:45 AM
The Value of Flexibility in Sequencing Growth Investments
Peter Kort, Tilburg U. & U. of Antwerp
Pauli Murto, Helsinki School of Economics
Grzegorz Pawlina, Lancaster U.

We analyze the investment decision of a firm which has an option to complete an investment project in two stages instead of undertaking it at a single point in time. The firm faces a trade-off between this additional flexibility and the total cost since completing the investment in two steps is more costly. We derive the optimal investment rule and show that higher uncertainty makes the lump investment more attractive than the sequential investment. Furthermore, we derive the optimal fraction of the project to be invested in the first and the second stage and obtain that the optimal size of investment in the first stage is positively related to uncertainty. Finally, despite the fact that higher uncertainty favors the lump investment, we show that it can make the sequential investment more likely. We illustrate our model with a case study and calibrate its parameters using actual market data.

Friday Track I 10:30 -12:10

Valuing Commodities & Natural Resources
Chairperson: Jaime Casassus, PUC - Chile

10:30 AM
Optimal Investment Scale and Timing in Oilfield Development
Marco A. G. Dias, Petrobras & PUC - Rio de Janeiro
Katia Rocha, IPEA & PUC - Rio de Janeiro
José Paulo Teixeira, PUC - Rio de Janeiro

The oil company holds the investment opportunity to develop a delineated oilfield. The investment plan must be presented until a specific date or the oilfield rights return to the government. The firm considers a set of mutually exclusive alternatives of scale to exploit the oilfield. Larger scale means faster exploitation, increasing the present value of revenues, but also higher investment cost. Oil price uncertainty affects all alternatives. In addition to the scale option, the firm has a timing option and hence this investment opportunity is analog to a finite-lived American call option on the best of multiple assets with the same underlying oil price stochastic process but with different benefits and different exercise prices. We examine both geometric Brownian motion and a mean-reversion process to model oil prices. We obtain the undeveloped oilfield (real option) value and the optimal investment rules, i.e., the optimal timing and the optimal scale thresholds.

10:55 AM
Operating Options and Commodity Price Processes
Manle Lei, U. of Guelph - Canada
Glenn Fox, U. of Guelph - Canada

This paper discusses the short-run dynamics of commodity prices. It deals with the interrelationships between price, inventory and price volatility as well as the effects of inventory and the producers’ operating flexibility on the dynamics of price in the short-run. It also illustrates how to model and estimate the stochastic process of commodity prices. We conclude that, in the short-run, producers’ operating flexibility reduces price volatility when the spot price is higher than the threshold price causing expansion in the scale of operations. However, we also conclude that operating flexibility can increase price volatility when the spot price is lower than the threshold price resulting in a contraction of operations. We demonstrate the failure of currently used parametric models in describing the stochastic process of commodity prices and suggest using non-parametric methods. We also recommend including the time trend in such a model.

11:20 AM
Valuation of Commodity Options and the Option to Invest with Incomplete Information
Mondher Bellalah, U. de Cergy - France

This article extends the three models in Schwartz (1997) to describe the stochastic behavior of commodity prices in the presence of mean reversion and shadow costs of incomplete information. The implications of the models are studied with respect to the valuation of financial and real assets. We extend the analysis in Schwartz (1997) to account for the effects of shadow costs of incomplete information as defined in Merton (1987).
The first one-factor model assumes that the logarithm of the spot commodity price follows a mean reverting process. The second model is a two-factor model in which the convenience yield is stochastic. The third model accounts for stochastic interest rates. The implications of the models are studied for capital budgeting decisions.
We develop also a one-factor model for the stochastic behavior of
commodity prices which preserves the main properties of more complex two-factor models. When applied for the valuation of long-term commodity projects, the model gives practically the same results as more complex models.

11:45 AM
Equilibrium Commodity Prices with Irreversible Investment and Non-Linear Technologies
Jaime Casassus, PUC - Chile
Pierre Collin-Dufresne, U. California - Berkeley
Bryan Routledge, Carnegie Mellon U.

We model the properties of equilibrium spot and futures oil prices in a general equilibrium production economy with two goods. In our model production of the consumption good requires two inputs: the consumption good and a Oil. Oil is produced by wells whose flow rate is costly to adjust. Investment in new Oil wells is costly and irreversible. As a result in equilibrium, investment in Oil wells is infrequent and lumpy. Equilibrium spot price behavior is determined as the shadow value of oil. The resulting equilibrium oil price exhibits mean-reversion and heteroscedasticity. Further, even though the state of the economy is fully described by a one-factor Markov process, the spot oil price is not Markov (in itself). Rather it is best described as a regime-switching process, the regime being an investment `proximity' indicator. Further, our model captures many of the stylized facts of oil futures prices. The futures curve exhibits backwardation as a result of a convenience yield, which arises endogenously due to the productive value of oil as an input for production. This convenience yield is decreasing in the amount of oil available in the economy. We test out model using crude oil data from 1982 to 2003. We estimate a linear approximation of the equilibrium regime-shifting dynamics implied by our model. Our empirical specification successfully captures spot and futures data. Finally, the specific empirical implementation we use is designed to easily facilitate commodity derivative pricing that is common in two-factor reduced form pricing models.

Friday Track II 10:30 am - 12:10 pm

Competition and Strategy
Chairperson: Marcel Boyer, U. Québec - Montréal, CIRANO & CIREQ

10:30 AM
Strategic Investment in Networks
Nalin Kulatilaka, Boston U.
Lihui Lin, Boston U.

We examine how the presence of network effects influences investment decisions. Building a network requires significant upfront investment but benefits carry tremendous uncertainty. This creates an incentive to defer the commitment of irreversible investments. However, such investments may also create the opportunity to convince the consumers about the network's size, establish a network standard, and preempt future competitors. Our models account for the tradeoff between these countervailing forces to obtain the investment rules for building networks. First, we study the investment decision faced by a monopolist in both the investment opportunity and product market. By investing prior to the resolution of uncertainty, the monopolist convinces the consumers of the network size. We solve for the threshold level of expected demand which must be exceeded in order to commit the investment. This threshold is lowered by an increase in the intensity of the network effect but the effect of uncertainty on the investment threshold is ambiguous. Our second model allows for future competitor entry where the entrant may either adopt the monopolist's standard or build its own network. We find that the optimal licensing fee may be lower than the highest level that the entrant would accept. When future competition is anticipated, the investment threshold is monotonically decreasing in both the intensity of network effects and the level of uncertainty.

10:55 AM
A Two-stage Investment Game in Real Option Analysis
Junichi Imai, Iwate Prefectural University (IPU)
Takahiro Watanabe, Tokyo Metropolitan U.

This paper investigates an interaction between the managerial flexibility and the competition. We consider a two-stage game with two firms under demand uncertainty that follows a one-period binomial process. The cash flow generated from a project depends on both the demand and the firms' actions. We assume that the two firms make decisions sequentially at each stage whether they invest in the follow-up project. One firm called a leader primally makes a decision, and the other firm called a follower decides secondly after observing the leader's decision. Namely, a leader has a competitive advantage over a follower. Both firms' managers can invest at either of stages, hence they can defer their decisions for investment at the first stage. This means that they have flexibility to defer the project until the second stage. This flexibility can be considered a real option to defer the project. Although the model developed here is very simple the implication from the model is plentiful. We fully characterize the equilibrium strategies for both firms which are classified by their investment costs. We consider situations where either or both firms can invest only at the first stage. By comparison among these situations, we can analyze the effects of flexibility and competition. Our results indicate that under a monopolistic environment the existence of flexibility has a positive impact on the project value. However, under the competitive environment the effects of flexibility are not straightforward. For a follower obtaining the flexibility always increases the project value. On the other hand, a leader could decrease a project value by obtaining the flexibility on the condition that the follower can invest only at the first stage. We call it flexibility trap and this result can be interpreted as commitment effects in game theory.

11:20 AM
Third Generation Mobile Games
Dean Paxson, Manchester Business School
Helena Pinto, Manchester Business School

The third generation technology will confer to mobile phones all the capacity and speed of a fixed line phone with the additional flexibility of mobility. Major investments in 3G installation facilities are planned in developed economies; the reported investment plans indicate "leader-follower" patterns.

Using three real competition options models, we determine the optimal timing of 3G investment of one Portuguese mobile company, Optimus, taken as the follower. In the first of those models both the number of units sold and the cash flow per-unit of the players follow separate but possibly correlated geometric Brownian motion. In the second model the investment cost and the operating cash flow are the state variables. The third model assumes that the investment cost and the operating cash flow stream of the total market follow separate geometric Brownian motion and that the market share of the follower occurs according to a Poisson process.

Consistent parameters are used to derive the leader and follower value functions for different models, which are compared to a traditional NPV valuation analysis. A positive NPV points to the acceptance of the investment and the immediate entry of all of the players in the market.

The results of all the models point to the delay of the entry of the follower, which might account for the observed behaviour of the actual players.

Keywords: Competitive real options, Empirical application of real options, two factor models, duopoly

11:45 AM
Real Options and Strategic Competition
Marcel Boyer, U. de Montréal, CIRANO & CIREQ
Eric Gravel, CIRANO
Pierre Lasserre, U. Québec - Montréal & CIRANO

Among investment decision tools, real option theory is reaching advanced textbook status and is rapidly gaining reputation and influence. Although both popular writers and specialists warn against its often daunting complexity, they also stress its unique ability to take account of future flexibility and the importance of future moves and decisions in valuing current investments. The real options approach emphasizes the indivisibility and irreversibility of investments; indivisibilities often imply a limited number of players, hence imperfect competition. Yet, while it is often stressed that real option theory is best to analyze investments of strategic importance -- the word 'strategic' appears repeatedly in the real-options literature -- the bulk of that literature involves decision makers playing against nature rather than against other players. The analysis of strategic considerations, in a game theoretic sense, is still in its infancy and should be high in the real-option research agenda. Our paper reviews the main contributions, presents a unified approach and identifies the most significant challenges.

Friday 12:15 - 1:45

Luncheon Address
The Price of Everything
Michael J. Brennan
, UCLA Anderson School

Friday Track I 1:45 pm - 3:00 pm

Valuing Power Investments
Chairperson: Gordon Sick, U. of Calgary

Choice of Electric Power Investments under Uncertainty: The Value of Modularity
Christian Gollier, U. de Toulouse
David Proult, Commissariat à l'Energie Atomique
Françoise Thais, Commissariat à l'Energie Atomique
Gilles Walgenwitz, Commissariat à l'Energie Atomique

We consider the decision making of a firm in the electricity sector facing two alternative investment projects. The first possible outcome is an irreversible investment in a large nuclear power plant. The second one consists in building a flexible sequence of smaller, modular, nuclear power plants on the same site. In other words, we compare the benefit of the large power plant project coming from increasing returns to scale, to the follow-on opportunities offered by the modular project to adapt the investment strategy depending on the level of risk. We use the theory of real options to measure the value of the sequence of decisions to invest in the successive modules, under price uncertainty. From this theory, it is well-known that risk-neutral entrepreneurs will decide to invest only if the market price of electricity exceeds the cost of electricity production by a positive margin which is an increasing function of the market risk. In particular, this margin is larger for the irreversible investment than for the modular project. This is because the investment process in the modular project can be interrupted at any time when the market conditions deteriorate, thereby limiting the potential loss of the investor. We consider in particular an environment where the discount rate is 8% and volatility of the market price of electricity equals 20% per year. The modular project consists in four units of 300 MWe each, with 40% of the total overnight cost borne by the first module. We show that the benefit of modularity is equivalent in terms of profitability to a reduction of the cost of electricity by one-thousand of a euro per kWh.

2:10 PM
Flexibility and Technology Choice in Gas Fired Power Plant Investments

Erkka Näsäkkälä, Helsinki U. of Technology
Stein-Erik Fleten, Norwegian U. of Science and Technology

The value of a gas fired power plant depends on the spark spread, defined as the difference between the unit price of electricity and the cost of gas. We model the spark spread using two-factor model, allowing mean-reversion in short-term variations and uncertainty in the equilibrium price to which prices revert. We analyze two types of gas plants. The first type is a base load plant, generating electricity at all levels of spark spread. The second type is also a base load plant from the outset, but can be upgraded, at a cost, to a peak load plant generating electricity only when spark spread exceeds emission costs. We compute optimal building and upgrading thresholds for such plants when the plant types are mutually exclusive. Our results indicate that selecting a project which is first profitable leads to a non-optimal investment policy, and that increase in short-term volatility preempts upgrading whereas increase in equilibrium volatility delays upgrading.

2:35 PM
Valuing Power Derivatives: a Two-Factor Jump-Diffussion Approach
Pablo Villaplana, U. Pompeu Fabra - Spain

We propose a two-factor jump-diffusion model with seasonality for the valuation of electricity future contracts. The model we propose is an extension of Schwartz and Smith (Management Science, 2000) long-term / short-term model. One of the main contributions of the paper is the inclusion of a jump component, with a non-constant intensity process (probability of occurrence of jumps), in the short-term factor. We model the stochastic behaviour of the underlying (unobservable) state variables by Affine Diffusions (AD) and Affine Jump Diffusions (AJD). We obtain closed form formulas for the price of futures contracts using the results by Duffie, Pan and Singleton (Econometrica, 2000). We provide empirical evidence on the observed seasonality in risk premium, that has been documented in the PJM market. This paper also complements the results provided by the equilibrium model of Bessembinder and Lemmon (Journal of Finance, 2002), and provides a simple methodology to extract risk-neutral parameters from forward data, that may be used for calibration of real options models. The model may also be used for scenario generation, valuation of financial options (trough inversion of the characteristic function) and real options applications.

Friday Track II 1:45 pm - 3:00 pm

Competition & Games
Chairperson: Marco A. G. Dias, PUC-Rio de Janeiro & Petrobras

1:45 PM
Continuous-Time Option Games/Review of Models and Extensions: Oligopoly and War of Attrition
Marco A. G. Dias, PUC-Rio de Janeiro & Petrobras
Jose Paulo Teixeira, PUC-Rio de Janeiro

This sequel paper analyzes other selected methodologies and applications from the theory of continuous-time (real) option games - the combination of real options and game theory. In the first paper (Dias & Teixeira, 2003), we analyzed preemption and collusion models of duopoly under uncertainty. In this second paper we focus on models of oligopoly under uncertainty and war of attrition under uncertainty. We also review the literature on other option games models such as models of positive externalities with network effects, models with either incomplete or asymmetric information, evolutionary option games, the models limitations, and suggestions for future research. In the oligopoly model we follow Grenadier (2002), discussing two important methodological insights that simplify many option games applications: the Leahy's principle of optimality of myopic behavior and the "artificial" perfectly competitive industry with a modified demand function. We discuss both the potential and the limitations of these insights. Next, we extend to the continuous-time framework the option game model presented in Dias (1997), a war of attrition under uncertainty applied to oil exploration prospects. In this model of positive externality the follower acts as free rider receiving additional information revealed by the leader's drilling outcome. The way to model the information revelation in oil exploration is another extension of the original option game model. In this model we have three different kinds of uncertainties, namely the market uncertainty (oil prices), technical uncertainty (existence, quality and volume of a oil reserve), and strategic uncertainty (incomplete information on the other player). In addition, we analyzed the possibility of coordination by the oil companies be perfect Nash equilibrium, changing the game depending on the information revelation parameters. We also show that the option game premium can be much higher than the traditional real option premium in either war of attrition or cooperation when the latter is Nash equilibrium. This is generally the opposite of the oligopoly under uncertainty case, when the option game premium is lower than the traditional, is zero in the limit of infinite firms, and can be even negative in special preemption cases.

Keywords: option games, option exercise games, real options, stochastic game theory, oligopoly under uncertainty, war of attrition under uncertainty, information revelation, incomplete information, option game premium, Leahy's optimality of myopic behavior.

2:10 PM
The Optimal Decision to Invest in a Duopoly Market for (Two) Positioned Companies when there are Hidden Competitors
Paulo J. Pereira, U. of Minho - Portugal
Manuel J. Armada, U. of Minho - Portugal

The aim of this paper is to study the option to invest in a duopoly market, allowing for more competitors to enter the market. In fact, we relax the common assumption which states that (only) two firms compete for the two places in the market. In the existing models, the problem consists of, basically, defining which one will be the leader, which will be the follower, and when. We can say that, in these settings, the investment opportunities are semi-proprietary, since the follower's position is, at least, guaranteed for both firms. As we said, our approach relaxes this assumption, allowing for more than two competitors for the positions on the duopoly. This additional competition has, as we will see, a major impact on the decision to invest. We also allow for both ex-post symmetry and ex-post asymmetry, and for asymmetrical investment costs for the leader and for the follower.

2:35 PM
Vulnerable Options in Supply Chains: Effects of Supplier Competition
Volodymyr Babich, U. of Michigan

This paper presents valuation of inventory-reorder options in a competitive environment with defaultable suppliers. Analysis of a single period model of a supply chain with two suppliers, a retailer, and exogenous sources of defaults, leads to a number of surprising observation on the effects of the supplier credit risk and competition on the value of the deferment option, retailer's procurement and production decisions, suppliers' pricing decisions, and firms profits. In particular, when wholesale prices are fixed, introduction of the deferment option may benefit the supplier with longer production lead-time at the expense of the supplier with shorter production lead-time and there are conditions for the retailer's profit to be increasing in default correlation. When wholesale prices are allowed to vary, analysis of the game between suppliers shows that introduction of the deferment option diminishes competition between suppliers and, thus, hurts the retailer if supplier defaults are highly correlated. On the other hand, retailer's profit is increasing in supplier default correlation if the level of correlation is low.

Friday Track I 3:30 pm - 5:10 pm

Valuing Infrastructure & Network Investments
Chairperson: Dohyun Pak, U. of Michigan

3:30 PM
From Access to Bypass
Keizo Mizuno, Kwansei Gakuin U. - Japan
Keiichi Hori, Ritsumeikan U. - Japan

This paper examines firms' incentives for irreversible investments in network industries with a stochastically growing demand. An access-to-bypass strategy equilibrium is characterized in terms of an access charge premium and an incrmental profit flow accrued from access to bypass. We then discuss some properties of the investment timings in the equilibrium, such as the preemption effect, the role of opportunity to access an incumbent's network facility, the effects of uncertainty and the access charge. The feasiblity of the optimal investment timing is also examined.

3:55 PM
A Real Option Approach to Telecommunications Network Optimization
Dohyun Pak, U. of Michigan
Jussi Keppo, U. of Michigan

We optimize network flow by minimizing network blocking and/or delay and by modeling network routing possibilities as real options. The uncertainties in the network are driven by stochastic point-to-point demands and we consider correlations among them in a general network structure. We derive an analytical approximation for the blocking/delay probabilities and solve the optimal network flows by using a global optimization technique. We illustrate the model with examples.

4:20 PM
Building Real Options into Physical Systems with Stochastic Mixed-Integer Programming
Richard de Neufville, MIT
Tao Wang, MIT

The problem of building real options into physical systems has three features:

  • real options are not as easily defined as financial options;
  • path-dependency and interdependencies among projects mean that the standard tools of options analysis tools are insufficient; and
  • the focus is on identifying the best way to build flexibility into the design — not to value individual options.

This paper suggests a framework for exploring real options in physical systems that especially addresses these two difficulties. This framework has two stages: options identification and options analysis. The options identification stage consists of screening and simulation models that focus attention on a small subset of the possible combination of projects. The options analysis stage uses stochastic mixed-integer programming to manage the path-dependency and interdependency features. This stochastic formulation enables the analyst to include more technical details and develop explicit plans for the execution of projects according to the contingencies that arise. The paper illustrates the approach with a case study of a water resources planning problem, but the framework is generally applicable to a variety of large-scale physical systems.

Keywords: real options, stochastic mixed-integer programming, physical systems, and water resources planning

4:45 PM
Investing in Transportation Infrastructure Under Uncertainty
Jean-Daniel Saphores, U. California - Irvine
Marlon Boarnet, U. California - Irvine

We analyze the impact of uncertainty and irreversibility on the timing of building urban transportation infrastructure. We consider a monocentric urban area where the population varies stochastically in continuous time, which impacts land rents, land prices, and transportation costs through congestion. A transportation agency can decide if and when to build transportation infrastructure that reduces congestion. A numerical application using realistic parameters illustrates the interplay between volatility and the lower and upper bounds on the city's population. Our results highlight the importance of accounting for the value of the option to build infrastructure in a benefit/cost analysis.

Friday Track II 3:30 pm - 5:10 pm

Valuation Issues & Applications
Chairperson: Sigbjørn Sødal, Agder U. - Norway

3:30 PM
Valuation of Intellectual Capital
Sudi Sudarsanam, Cranfield U.
Ghulam Sorwar, Cardiff U.
Bernard Marr, Cranfield U.

Intellectual capital is an increasingy major component of the total capital of firms as firms move from manufacturing and industrial activitities towards services and more knowledge-based activities. Relative to the other components of a firm's capital such as physical and monetary capital, intellectual capital (IC)is more difficult to define, measure, manage and value in the traditional sense. Yet given the profound importance of such assets to firm's competiitve advantage and value creation capabilities, serious attempts need to be, and increasingly are, made to establish clear definitions, measurement rules and vauation principles. In this paper we discuss intellectual capital from a valuation perspective. We examine the nature of such capital and why traditional valuation models fail to reflect the unique characteristics of IC. We devlop a valuation perspective based on real options models that have been extended from their origins in financial asset valuation to the valuation of firms' growth opportunities. Intellectual assets embody these opportunities contributing to both their evouton over time and their realization in the future. This approach provides a richer framework to anayse the issues that confront the valuation of IC than traditional valuation approaches.

3:55 PM
Modelling Suicide Risk in Later Life
Chi-Fai Lo, Chinese U. of Hong Kong

Affective disorder is generally regarded as the prominent risk factor for suicide in the old age population. Despite the large number of empirical studies available in the literature, there is no attempt in modelling the dynamics of an individual? level of suicide risk theoretically yet. In particular, a dynamic model which can simulate the time evolution of an individual? level of risk for suicide and provide quantitative estimates of the probability of suicide risk is still lacking.

Aims and Methods: In the present study we apply the contingent claims analysis approach of credit risk modelling in the field of quantitative finance to derive a theoretical stochastic model for estimation of the probability of suicide risk in later life in terms of a signalling index of affective disorder. Our model is based upon the hypothesis that the current state of affective disorder of a patient can be represented by a signalling index and exhibits stochastic movement and that a threshold of affective disorder, which signifies the occurrence of suicide, exists.

Results and Conclusions: According to the numerical results, the implications of our model are consistent with the clinical findings. Hence, we believe that such a dynamic model will be essential to the design of effective suicide prevention strategies in the target population of older adults, especially in the primary care setting.

4:20 PM
Investment Applications in the Shipping Industry: An Overview
Christian Hopp, U. of Konstanz
Stavros Tsolakis, Erasmus U. - Rotterdam

This paper introduces Real Option Analysis and exotic options in particular as an alternative to the traditional capital budgeting technique for evaluating a series of shipping projects. The paper considers the option to expand, timing and defer options, the option to choose the best of two assets and the option to vary the firm's production methods. Compound option are used to value the expansion option through ordering an additional number of ships at a predetermined price, showing that such options may increase the shareholders' value substantially. Also a framework to critically assess asset play opportunities is developed. Furthermore, by evaluating investment opportunities using American Exchange Options, substantial differences are found compared to the NPV method in both the value of the investment opportunities and the timing of when the project is undertaken. Chooser options are employed to evaluate the various options open to a shipowner in order to optimise strategic decision making process. Finally, Exchange options are used to value the decision to invest in a new ship type. Overall Real Options are useful tools for evaluating projects in an industry as volatile as shipping, where the agents need to value complex projects and make timely strategic decisions on a regular basis.

4:45 PM
Market Switching Options for Shipping Carriers
Sigbjørn Sødal, Agder U. - Norway
Steen Koekebakker, Agder University
Roar Aadland, Clarksons Research & Agder U. - Norway

The paper derives and applies a net present valuation model of flexibility under mean-reverting prices. The model is an Ornstein-Uhlenbeck version of a standard entry-exit model as in Dixit (1989). It is applied empirically to international shipping, valuing the option to switch between the dry bulk and wet bulk market segments for a combination carrier, which is more expensive to buy than conventional oil tankers and drybulk ships. A fixed cost is incurred every time the combination carrier switches between the segments. The estimated value of flexibility is related to historical price differentials between combination carriers and ships with no such flexibility. Various thresholds for when combination carriers are more profitable are discussed, conditional on how freight rates are correlated, the size of the switching costs, and vessel cost differences.

Friday 5:15 pm - 6:15

Keynote Address
Real Options After 27 Years
C. Myers, MIT Sloan School

Dr. Myers is the Gordon Y Billard Professor of Finance at the Massachusetts Institute of Technology's Sloan School of Management. He is past President and Director of the American Finance Association, and co-author of the leading graduate-level textbook on corporate finance. His research is primarily concerned with the valuation of real and financial assets, including real options, corporate finance and governance, and financial aspects of government regulation of business.
Professor Myers was the first to point out the existence and importance of real options in his 1997 Journal of Finance article on the “Determinants of Corporate Borrowing,” which spawned the growth of this new and vibrant field. He has followed on with analysis of the abandonment option, applications in pharmaceuticals and other areas, and helped establish the new field through acceptance in finance textbooks.
Professor Myers is a Research Associate of the National Bureau of Economic Research and a Principal of The Brattle Group, Inc. He is active as a financial consultant.

Saturday 7:30 am - 8:30 am


Saturday Track I 8:30 am - 10:10 am

Technology Investments
Chairperson: Pierre Lasserre, U. Québec - Montréal & CIRANO

8:30 AM
Quantifying the Strategic Option Value of Technology Investments
Han Smit, Erasmus U., Rotterdam
Lenos Trigeorgis, U. Cyprus

We develop an integrated real options and industrial organization framework to quantify the strategic option value of technology investments. Strategic investments (e.g., R&D, capacity expansion or strategic acquisitions) are difficult to analyze based on standard approaches. Yet, it is these decisions that determine a firm’s competitive success in a changing technological and competitive landscape. How much is a strategic option (e.g., Microsoft’s growth opportunities) worth? How does one analyze strategic options in a dynamic, competitive environment? We describe basic principles for analyzing competitive strategies under uncertainty based on an integration of real options with game theory. We analyze multi-stage investment decisions facing a firm under uncertainty, both under a proprietary setting and when facing exogenous or endogenous competition (both in the last stage of commercialization as well as in the innovation or R&D stage). Competitive strategies may differ, e.g., depending on the type of investment (proprietary or shared) and the nature of competitive reactions (strategic substitutes or complements). The benefits of cooperation (via joint R&D ventures) vs. direct R&D competition (innovation races) are also discussed. Finally, we analyze multiperiod option games with endogenous volatility and discuss various other extensions.

8:55 AM
Technological Portfolio Diversification
Ilhem Kassar, U. Québec - Montréal
Pierre Lasserre, U. Québec - Montréal & CIRANO

We investigate the notion of portfolio in a real options framework; more precisely, we study an investment problem when competing technologies are able to achieve a specific production objective while having the potential to generate operating options. What combination of assets should be acquired? According to which decision rules?

A firm has the opportunity to acquire production units of a given capacity. Two technologies are available, with different risk characteristics. Besides the choice between the two competing technologies, the investor has to decide how many capacity\ units to install (growth options) with no constraints on technological uniformity or timing. Thus the firm may decide to hold zero units, one unit of either type, two units of one type, two units of the alternative type, one unit of each type, etc. We limit the analysis to two units, but the methodology can be extended to many units.

Changes in the production scale of any unit of capacity are costless; this gives a technologically diversified firm a certain operating flexibility to adjust to fluctuations in production costs. This operating flexibility is similar to a switch option, but differs in three important ways: first any combination of production between two units is possible, subject to the capacity of each unit; second, for the owner of two different units, taking advantage of operating flexibility involves letting the (currently) least efficient unit sit totally or partially idle; finally, the operating flexibility option may be acquired as a one shot purchase of two capacity units, or as a decision to extend capacity by choosing a different technology at the second acquisition. This apparently benign feature in the acquisition of a technology portfolio that, ex post, may be considered a flexible package, turns out to make an important difference in the acquisition process and the ex ante evaluation of the units.

In the model described above, with its multiple underlying options, we analyze the operational and investment decision processes and show how and under which conditions portfolio optimization leads to a technologically diversified, or a specialized, portfolio. The analysis emphasizes that project evaluation is firm and history specific in such a context.

Key words: Real options; Portfolio; Flexibility; History.
J.E.L. classification: C610, D92; G11, G12.

9:20 AM
Irreversible Investment in Alternative Projects
Jean-Paul Décamps, U. de Toulouse
Thomas Mariotti , U. de Toulouse & London School of Economics
Stéphane Villeneuve, U. de Toulouse

We examine the problem of a risk-neutral investor who has to choose among two alternative projects of different scales under output price uncertainty. We show that as soon as investment in the smaller scale project is sometimes optimal, the optimal investment strategy is not a trigger strategy and the optimal investment region is dichotomous. Whenever the investor has the opportunity to switch from the smaller scale to the larger scale project, the dichotomy of the investment region can persist even when uncertainty becomes large.

9:45 AM
Optimal Scrapping and Technology Adoption under Uncertainty
Hervé Roche, ITAM Mexico

A firm has to decide sequentially to replace its technology and to implement a new one chosen among an increasing range over time under technological and market uncertainty. The optimal decision rule is a (s,S) style policy where the trigger and target technology levels are positively correlated with boom persistence and negatively related with recession persistence and technological uncertainty. The average time between two adoptions is governed by several factors. Bounded technological progress imposes a limitation on the best grade available, which can accelerate updating when the firm wishes to continue to operate an advanced technology. Technological uncertainty reinforces depreciation and thus hastens replacement. Moreover, both types of uncertainty have an impact on the scrapping and upgrading levels. Overall, adoption is more frequent for economies spending a large fraction of time in booms. The likelihood of switching during a recession is negatively affected by the arrival rate of booms. The end of a recession can trigger updating since the firm will want to operate an efficient technology in order to seize the high cash flows associated with the forthcoming boom. This result implies that investment spikes are procyclical.

JEL Classification: D81, D92, O33 Keywords: Technological Uncertainty, Market Uncertainty, Optimal Timing, Innovation Adoption, Option Value

Saturday Track II 8:30 am - 10:10 am

Theoretical Issues
Chairperson: Vicky Henderson, Princeton U.

8:30 AM
Smooth Pasting as Rate of Return Equalisation
Sigbjørn Sødal, Agder U. - Norway
Mark Shackleton, Lancaster University

In this short note we elucidate the smooth pasting condition that is behind the optimal early exercise condition of options. It is almost trivial to show that smooth pasting implies rate of return equalisation between the option and the levered position that results from exercise. This yields new economic insights into the optimal early exercise condition that the option holder faces.

8:55 AM
Valuing Options to Learn: Optimal Timing of Information Acquisition
Pauli Murto, Helsinki School of Economics

This article considers the value of information and optimal timing to acquire it in a model of irreversible investment. There are two types of uncertainties: the value of the investment project depends on
1) an observable stochastic process and
2) an ex-ante uncertain parameter, whose true value may be learnt at a cost.
The former type of uncertainty implies that the opportunity to acquire information has an option-like character. We derive and characterize the value of such learning options and the optimal timing to learn.

9:20 AM
Real Options Valuation within Information Uncertainty
Mondher Bellalah, U. de Cergy, France

This paper develops some results regarding the economic value added and real options. We use Merton’s (1987) model of capital market equilibrium with incomplete information to introduce information costs in the pricing of real assets. This model allows a new definition of the cost of capital in the presence of information uncertainty. Using the methodology in Bellalah (2001, 2002) for the pricing of real options, we extend the standard models to account for shadow costs of incomplete information.
Keywords : EVA, real options, information costs
JEL Classification : G12, G20, G31

9:45 AM
Valuing Real Options without a Perfect Spanning Asset
Vicky Henderson, Princeton U.

The real options approach to corporate investment decision making recognizes a firm can can delay an investment decision and wait for more information concerning project cashflows. The classic models of McDonald and Siegel (1986) and Dixit and Pindyck (1994) value the investment decision as a perpetual American option and in doing so, essentially assume the real asset underlying the option is traded, or that there is a perfect spanning asset available. Our model relaxes this assumption and assumes only a partial spanning asset can be found. In this model, we obtain in closed form the value of the option to invest and the optimal investment trigger level, above which investment takes place. These both depend additionally on the correlation between project cashflows and the spanning asset, risk aversion of the firm's shareholders, and volatilities of project cashflows and the spanning asset. The value of the option to invest and the trigger level are both lowered when the spanning asset is less than perfect. Although the partial spanning model contains the classic model as a special case, it is much richer. In particular, there are parameter combinations where the classic model recommends the firm never invests, whereas if a highly (but not perfectly) correlated spanning asset were assumed, the firm should invest at a certain trigger level.

Saturday Track I 10:30 am - 11:45

Agency Issues
Chairperson: Bart Lambrecht, U. of Lancaster

10:30 AM
The Option to Change One Construction Contract for Another
Said Boukendour, U. du Québec - Outaouais

This article explores a new field of application for real options. That is to resolve the principal-agent problem arising in procurement contracts. The impossibility of writing complete and enforceable contracts gives the contractor the opportunity of earning by cheating. The best way of dealing with the problem is to design a contractual mechanism that would stop a self-interested contractor from taking benefit that would result from a postcontractual opportunism. This mechanism can be based upon conclusion of two types of contracts with an option that provides the owner the exclusive right of choosing at the expiration date which contract to apply. This mechanism looks like an option to change one contract for another. The fixed price contracts includes an option on cost-reimbursement contracts and vice versa. By this mechanism, the contractor will not be willing to behave to the detriment of the owner because the latter can exercise the option and the contractor will become the victim of its own actions.

10:55 AM
Concession Agreements in the Shipping Industry
Carmen Juan, U. of Valencia
Fernando Olmos, U. of Valencia
Trinidad Casasus, U. of Valencia
Juan Carlos Perez, U. of Valencia

In this paper we present a methodology for designing concession agreements in the shipping industry. Such methodology allows us making return-risk stochastic analysis of both parts of the concession agreement, quantifying the value of the risk transfers that underlie concessions, and finally valuing those sweeteners included in agreements that require a real options approach. We make use of standard stochastic return-risk analysis, joint with an specifically designed numerical algorithm for the sweeteners valuation. The implementation of the whole methodology has been done in Excel and is based on a broad empirical study of the expansion of Valencia Port.

11:20 AM
A Theory of Takeovers and Disinvestment
Bart Lambrecht, U. of Lancaster
Stewart Myers, MIT Sloan School

We present a real-options model of takeovers and disinvestment in declining industries. As product demand declines, a first-best abandonment level is reached, where overall value is maximized by shutting down the firm and releasing its capital to investors. Absent takeovers, managers of unlevered firms always abandon the firm’s business too late. We model the managers’ payout policy absent takeovers and consider the effects of leverage on managers’ shut-down decisions. We analyze the effects of takeovers of unleveraged or under-leveraged firms. Takeovers by raiders enforce first-best abandonment. Hostile takeovers by other firms occur either at the first-best abandonment point or too early. We also consider management buyouts and mergers of equals and show that in both cases closure happens inefficiently late.
JEL Nos.: G34, C72, G13.
Keywords: disinvestment, takeover, real option, managerial incentives, payout, debt

Saturday Track II 10:30 am - 11:45 am

Computational Issues & Approaches
Chairperson: Bardia Kamrad, Georgetown U.

10:30 AM
Estimation of Volatility of Cross Sectional Data: A Kalman Filter Approach
Cristina Sommacampagna, U. of Verona
Gordon Sick, U. of Calgary

In order to perform a Real Option evaluation some variables have to be estimated. One of the main variables to estimate is the volatility of the variable underlying the option. With respect to the financial options, because of the different objects of the evaluation, the available data can need a specific kind of analysis. In this document we consider the case of a crude oil producing company that collected data about the past costs of drilling wells and now wants to evaluate the real option of starting drilling new wells: we need to estimate the volatility of the drilling costs.

Keywords: Real Options; Cross-Sectional Data; Kalman Filter.

10:55 AM
Market and Process Uncertainty in Operations
Bardia Kamrad, Georgetown U.
Keith Ord, Georgetown U.

By adopting a real options framework, we develop and analyze a production control model that jointly incorporates process and market risks. In our model, process risk is typified by random yield variability while market risk is defined through demand uncertainty. The stochastic processes used to depict uncertainty in these state variables reflect a wide variety of distributional forms and are not confined to the traditional processes typically used in the real options literature. In our approach, the production inputs represent renewable, partially renewable or non-renewable resources. Furthermore, the production outputs are treated as non-traded assets, so that the model has a much broader range of applicability beyond that of standard commodities for which futures contracts trade. Given this setting, techniques of contingent claims analysis and stochastic control theory are employed to obtain value maximizing production policies in a constrained capacity environment. In light of the stochastic nature of the state variables, the rate of production is modeled as an adapted positive real-valued process and analogously evaluated as a sequence of complex real options. As the optimal adjustments to the rate of production also depend on the outputs? yield, we establish and explore 'flexibility triggers' justifying variations to the rate of production over time. This is achieved by providing closed form analytic results in the presence of generalized diffusion processes including mean reverting processes for the state variables to follow. We also use a numerical example to highlight the model's sensitivity and contingent features.

11:20 AM
Valuing the Surrender Options Embedded in a Portfolio of Italian Life Guaranteed Participating Policies
Giulia Andreatta, RAS Spa - Italy
Stefano Corradin,
U. California - Berkeley & RAS Spa - Italy

We price the surrender option embedded in two common types of guaranteed participating Italian life contracts and we adopt the Least Squares Monte Carlo approach following Longstaff and Schwartz (2001) giving a comparative analysis with the results obtained through a Recursive Tree Binomial approach according to Bacinello (2003). We present an application to a major Italian life policies portfolio at two different market valuation dates. We use a Black & Scholes-CIR++ economy to simulate the reference fund; we estimate the fair value of portfolio's liabilities according to De Felice and Moriconi (2001), (2002) and Pacati (2000); extending the framework to price the embedded surrender options.

Saturday 12:00 - 1:00

Panel Discussion
Moderator: Gordon Sick, U. Calgary

Marcel Boyer, U. Québec - Montréal, CIRANO & CIREQ
Michael Brennan, UCLA
Bardia Kamrad, Georgetown U.
Bart Lambrecht, Lancaster U.
Stewart C. Myers, MIT
Lenos Trigeorgis, U. Cyprus and ROG

Thursday | Friday | Saturday



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