Downloadable pdf of Academic Program
Downloadable pdf of Managerial Program
Academic Program Sessions
Thursday, June 18, 2009
9:20 - 10:00 President's Address
Human Capital Flexibility
10:45 - 12:00 Infrastructure/Systems Investments
Private Infrastructure Investment Through Public
Private Partnership: An Application to a Toll Road Highway Concession in Brazil
Governments around the world have been encouraging private investments in infrastructure through Public Private Partnership (PPP) framework. In the transport sector, for example, project finance and PPP are largely used in toll road concessions. The PPP agreements may include subsidies, guarantees and other forms of support designed to reduce the risk to the private investor. Some real options can be identified in these structures and it is necessary to use the correct methodology to analyze project economic feasibility and risk allocation. Regarding the revenue risk in transport projects, different models of guarantees have been proposed. In Brazil, the 4th Line of the Metro of São Paulo is the first example of a PPP implementation and the mechanism used to mitigate the demand risk was based on minimum and maximum levels of demand. As an example of application, a hypothetical toll road concession is modeled and three real options are proposed and analyzed: a minimum traffic guarantee, a maximum traffic ceiling and an implicit option to abandon.
Identifying Real Options "In" Large-Scale Infrastructure Systems
There is a universe of real options opportunities for infrastructure development that are not fully considered in real options analysis literature. These are known as real options “in” infrastructures systems. They are design components embedded early on “in” the system design process – i.e. prior to fielding and operations – to enable time-to-build, scale alteration, product switching, and many other real options difficult to classify through a discrete set of categories suggested by Trigeorgis (1996). Real options “in” system require technical and engineering knowledge. This differs from real options “on” system focusing on managerial flexibility (e.g. investment deferral, abandonment, growth). Several example case studies show real options “in” system offer significant economic value improvement compared to a baseline inflexible design, ranging between 20% and 80%. Because real options “in” systems are numerous and different from one infrastructure to another, there is a need for analytical tools to guide the engineering effort for valuable opportunities. This paper illustrates some of the research issues involved in developing this field productively. It suggests a potential approach based on direct interactions, discussions, and close work with designers to enable real option opportunities “in” infrastructure systems.
Real Options in Economic Systems and Portfolio
“I contend that rational expectations theory totally misinterprets how financial markets operate. Although rational expectations theory is no longer taken seriously outside academic circles, the idea that financial markets are self-correcting and tend towards equilibrium remains the prevailing paradigm on which the various synthetic instruments and valuation models which have come to play such a dominant role in financial markets are based. I contend that the prevailing paradigm is false and urgently needs to be replaced.” (George Soros, 2008). This conceptual paper will take on the Soros challenge, using the concepts and methodologies of “real options in economic systems” and adding fresh thinking about data sources and the meaning of risk. It will examine the shortcomings and fallacies associated with modern portfolio and capital market theory and classical economics and ask many disquieting questions. General solutions, based in real options thinking, will be proposed and extended to the outer edge of global economic systems as found in the underground economies of the developing world.
1:15 - 2:30 Case Applications
Strategic Alliances, Contractual Options and Risk
Transfers in Land-Marine Transportation
This paper addresses the problem of the strategic planning of an intermodal transportation chain, and analyses potential risk transfers between agents in the chain derived from the real options embedded in the underlying agreements for the operations of the chain. A planning methodology is presented that enables the calculation of the Expanded Net Present Value (ENPV) when the material resources necessary to carry out the project (fleets and terminals) are not known a priori, and the choice of resources may change throughout the planning period. Based on the results of such planning, we propose methods to assess the transfers of risk among agents in the chain. Specifically, we focus on risks transfers arising from clauses regulating the operation of a compensation fund that can refund those agents who are more exposed to risk derived from uncertainty concerning demand for the service. The article also discusses the terms of the mechanisms that regulate a possible departure of one of the agents. Such clauses are stated in terms of partial or total put and call options.
Valuation of a Wind Farm Investment: An Application
The present paper values a Wind Farm investment project as a Compound Real Option. By combining the different uncertainties, we evaluate the volatility of the project. The value of the project is calculated using binomial lattices including Market and Private Risks.
When to Get in or Get Out: Analysis of Coffee
Planting in Brazil
The main objective of this study is to apply real options theory in the analysis of entry and exit prices regarding investments in coffee crop fields. We confront entry and exit strategies based on real options with neoclassical economics approach and with naïve strategies. Using market data for Arabic coffee, the results based on the real option approach lead to better results when comparing different strategies for implementing and abandoning investments in the culture of coffee.
Valuation of Social Investment: An Application to a
Highway Development Project in Mexico
Emerging economies are characterized by incomplete markets. Although significant financial and economic liberalization reforms have been implemented by their authorities during the last three decades, governments are still responsible for large shares of economic activity, Public works and public utilities are two areas where government intervention is still strong in many countries. Since no arbitrage solutions can be applied in incomplete markets current, research on real options has emphasized the private point of view disregarding the public point of view, particularly when public projects must also include a cost benefit analysis. This work overcomes this shortcoming proposing a real options approach for these types of projects integrating a theoretical framework for benefit-cost analysis and real options theory for the formulation and evaluation of public works carried out by either central or local authorities; based on this conceptual framework a full application of a real options cost benefit evaluation of a public highway development project, originally carried out by Secretaría de Communications y Transportes from Mexico.
2:45 - 4:00 Empirical Evidence
An Empirical Study of Technological Joint Venture
Drawing on the real options approach, we analyse which factors motivate firms to choose technological joint venture formation as their technology strategy. Scholars researching joint ventures through the real options lens have usually focused on the ending stage of the alliance rather than on its formation. Using a panel of 29 376 observations from 4050 manufacturing firms operating in Spain between 1998 and 2005, our results are consistent with real options approach predictions. We find that the greater the firm’s absorptive capacity and the higher the degree of technological risk, the more likely the firm is to form a technological joint venture. Results also suggest that the greater the risk of pre-emption by rivals and the higher the opportunity costs associated with technological joint venture formation, the less likely the firm is to choose such a technology strategy. A further step towards bridging the gap between finance theory and strategic analysis is thus taken.
The Impact of Growth Options on Systematic Risk:
Empirical Evidence from European Firms
This paper focuses on an analysis of the relation between systematic risk and growth opportunities from the real options perspective. Assuming the risk of current and future businesses to be independent from ownership (i.e. from whichever firm invests in them), we deduce that the systematic risk of a firm’s equity depends on the weight of growth options on its market value. We test this hypothesis by analysing a sample of 958 European firms over the period 2001-2005. Our findings bear out the impact of growth options on systematic risk and are robust to different splits of the sample into risk groups, thus providing new insights to interpret the findings to emerge from multifactor market models.
Deferral Option on Thermal Building Rehabilitation
Investment: Empirical Evidence from Residential Customers in Chech Republic
This paper examines option to defer an investment in thermal rehabilitation of building. Heat savings generated by energy efficiency investment in two distinctive areas connected to district heating in Prague are studied. Despite substantial difference of heat price over several years no significant difference in heat savings between the two areas is found. It is shown that different volatility of heat prices in different areas and its changes influencing value of deferral option can explain much of the observed flat owner’s behavior. Two specific “real” features of the deferral option are further introduced, improvement of the option valuation model is proposed and expected impact on the value of deferral option is discussed.
4:30 - 5:20 Keynote Address
Tranching and Rating
5:30 - 6:20 Panel Discussion
Luiz Brandao (PUC-Rio, Brazil)
6:30 – 8:00 Tour of Braga
Friday, June 19, 2009
9:00 - 10:15
I. Commodity Switching Options
Valuation of the Spark Spread in an LM6000 Power
Plant in Canada
This paper analyzes a power plant in Alberta, Canada, that is powered by two General Electric LM6000 gas turbines combined with a steam generator that allows combined cycle operations. The LM6000 is derived from a GE engine used on Boeing 767 and 747 airplanes, and is adapted for natural gas by General Electric. This power plant is popular in various power jurisdictions around the world as a turnkey power plant that can offer peaking capacity, and some baseload power delivery. We consider 4 operating modes for the plant: cold metal (off), 15 MW idle in combined cycle, full simple-cycle power (95 MW) and combined cycle full power (120 MW). A spark spread has two correlated stochastic variables: electricity price and natural gas price. To lower the dimensionality of the problem, we worked with heat rates. The market heat rate is the ratio of the electricity price to the natural gas price and the plant heat rate is the number of gigajoules (GJ) of gas needed to generate one MWh of electric power. This allows us to analyze the problem using the Margrabe approach, using natural gas as the numeraire commodity. We estimate a model for market heat rates that incorporates time of day, day of week, month and the incidence or otherwise of a spike in heat rates. We use the model and its residuals in a bootstrap process simulating future market heat rates, and use a Least Squares Monte Carlo approach to determine the optimal operating policy. We find that the annual average market heat rate is a good explanatory variable for the integral of the plant operating margin, denominated in the natural gas numeraire. This allows us to express plant values in terms of the numeraire and convert to dollars by multiplying this by the natural gas forward curve and a forward curve of riskless discount rates.
The Value of Switching Inputs in a Biodiesel Plant
There has been a growing concern in recent years about the quality of our environment and dependence on fossil fuels to supply the energy needs of the world, which has created an interest in the development of renewable and less polluting energy sources. One of these alternatives is the biodiesel fuel, which has many advantages over the fossil based diesel, or petrodiesel. In this paper we use the real options approach to determine the value of the managerial flexibility embedded in a biodiesel plant that has the option to switch inputs among different grain commodities. Our results indicate that the option to choose inputs has significant value if we assume that future prices follow stochastic processes such as Geometric Brownian Motion and Mean Reversion Models, and can be sufficient to recommend the use of input commodities that would not be optimal under traditional valuation methods. We also show that the choice of model and parameters has a significant impact on the valuation of this class of projects.
The Value of Switching Outputs in a Fertilizer Plant
in the US
This paper develops a theoretical model to value a real option on the best of two output commodities with continuous switching and temporary suspension possibilities and applies the model to a flexible fertilizer plant. The real options approach to flexibility sometimes suggests counter-intuitive decisions insofar as multi-million investments can be justified even if not currently profitable. Despite the high correlation between the two alternative commodities Ammonia and Urea, the value of flexibility may exceed the required investment cost for the downstream Urea plant, making a case for investment in flexible assets. The switching boundaries between the two operating states are found to be influenced more by the operating costs than by the switching costs. While the Continuous Rainbow option determines the shape of the asset value surface particularly for moderate to high commodity prices, the option to temporarily suspend the operation is highly relevant when prices are low. Both strategic and policy implications for stakeholders of flexible assets are discussed drawing on our numerical application to the fertilizer industry.
II. Optimal Investment (Timing & Scale)
Production Flexibility and Investment under
The theory of real options mainly considers problems where a firm must find the optimal time to invest in a certain project. We consider, besides the timing of the investment, the fact that the firm can also choose the quantity produced. We suppose that once the project is installed, it allows some flexibility in its operation at any instant, by varying some inputs not requiring irreversible commitments that extend over time. Then the optimal amount of output quantity will depend on the output price, at that instant, modelled in the form of an inverse demand function. We develop their approach allowing for various inverse demand functions. Depending on the realization of the stochastic process the optimal quantity can be adjusted at every instant. We outline two main points: First, the generalization of the inverse demand function provides the first result: Considering an iso-elastic inverse demand our model is similar to Dixit and Pindyck's <1994> considering a Cobb-Douglas production function. In both models one gets an always positive optimal quantity which means that once investment has been made the firm will produce forever. Considering a linear inverse demand function the optimal quantity can fall to zero. This means that one has take into account temporarily termination of production. Second, we want to know how much the firm can gain from this value of flexibility and how uncertainty influences these results. Therefore, we compare this model to one, where the firm just takes into account the timing decision. This means that after investment has been made the firm always produces up to capacity. Since firms often face constraints of limited capacity we take into account this restriction in a next step. This model is based on the previous one but the firm has to take into account capacity when it produces. After investment it either holds that quantity is equal to capacity or less than capacity, where the latter holds in case of a low realization of the stochastic process.
Optimal Investment, Capacity Choice and
In this paper, we formulate a firm’s investment in a production facility with maximum capacity and outsourcing strategy. Existing literature of capacity choice results in an explosive capacity and long delay in investment. Actually, there are slight possibility that a firm installs a facility with an explosive capacity, instead, a firm can outsource production when the demand exceeds its capacity. Outsourcing strategy is expected to inhibit the capacity, accelerate the investment and increase the value. In order to show these topics, we investigate optimal investment timing, facility’s size and outsourcing strategy simultaneously.
The Learning Curve and Optimal Timing and Intensity
The learning curve hypothesis states that unit costs decrease with cumulative production. While producing, a firm exploits a process of learning-by-doing that will lead to increased efficiency and lower production costs in the future. Majd and Pindyck (1989) determine the optimal production rate under uncertain demand and the learning curve hypothesis. They show that the conditions that make the firm willing to produce are less stringent. Even when marginal revenue is lower than marginal cost it may be optimal for the firm to produce. This is because, in addition to the value of generating profits, production has the additional value of reducing future marginal costs. However, Majd and Pindyck (1989) only focus on the production choice while the capital stock is fixed, implying that production capacity is given. We extend this research by studying the effects of learning by doing on capital investment. To do so we exploit the real options framework which allows us to analyze capacity choice in continuous time, while allowing for flexible timing of investment, irreversibility and an uncertain demand fluctuating over time. We consider a model analogous to the one proposed by Bar Ilan and Strange (1999) (BI&S, henceforth). In their model, as in ours, intensity is chosen once and for all at the moment of the investment. They show how, when investment is lumpy, comparative statics of intensity and timing are striking. In particular, an increase in uncertainty delays the investment but increase its intensity when it occurs. Other parameters also exhibit surprising effects. In this work we exploit their framework to investigate the effects of the learning curve on investment decisions. We obtain the following results. First, we the learning curve generates a significant scale effect. Second, the effects of the learning curve on timing and intensity of the investment are non-trivial. For given level of capacity and price, the value of capital for a firm that faces the learning curve is larger than the one of a firm that produces at constant marginal cost. Third, as in the constant marginal cost case, uncertainty delays the investment but increase its intensity. Furthermore, larger volatility weakens the scale effect generated by the learning curve. This result is readily explained. Higher volatility implies that both learning and constant marginal cost firms increase the scale of investment. In other words the firm's capacity would be in any case large independently of the presence of the learning curve. Thus, differences in the investment strategies, though still present, will be less detectable.
10:45 - 12:00
I. Energy Applications
The Value of Operational Flexibility to Add Thermal
to Hydropower: An Application in Norway
This paper presents a valuation study of operational flexibility for a hydropower operator restricted by contracts to deliver a steady flow of electricity to the contract counterpart. The hydropower operator has the flexibility to deliver from own production of hydro-electric generation, or deliver by buying option contracts of electricity from thermal electricity producers. The option may be in the form of a call option, or may be an implicit option created by having a separate thermal electricity plant that can be switched on and off. Long term industry contracts can make some operators obligated to always generate at a certain minimum level. Such operators cannot save the water in the reservoirs for peak price periods if this action compromises their ability to deliver the contracted minimum. If thermal generation is added and controlled, flexibility is enhanced and hence more generation can be allowed in peak price periods. To assess this value of operational flexibility the switching option model of Kulatilaka (1988) is applied. The numerical calculations, introducing nuclear, coal fired or gas fired generation, show an option value for a hydro operator also controlling thermal generation of NOK 65 / NOK 45 / NOK 13, respectively, per MWh yearly generation capacity.
Gas Storage Valuation Under Limited Market
Liquidity: An Application in Germany
Various approaches to natural gas storage valuation applying real options theory have been developed in recent years. Postulating storage operators as price takers these methodologies ignore the important fact that most evolving gas spot markets, like the German spot market, lack of liquidity. Thus, considering storage operators as price takers does not account for interdependencies of storage operations and market prices. This paper offers a new approach to storage valuation under respect of the effect of management decisions on market prices. The within this paper proposed methodology determines the optimal production schedule and value by applying a simple finite difference scheme on the stochastic differential equation describing the storage value. The paper is organized as follows: The first section introduces the valuation problem and gives an overview above recent research on gas storage valuation. Furthermore common definitions of market liquidity are introduced. Section 2 analyses possible liquidity measures to quantify the possible impact of storage operations to market prices. Subsequent the valuation methodology is described. The fifth section applies the methodology to an exemplary German storage facility.
Comparing Feed-In-Tariffs and Renewable Obligation
Certificates: The Case of Wind Farming in Germany
Policy makers in Europe and around the world see renewable energy as a clean alternative to fossil fuels and as a promise of long term security of supply. Today energy generated from renewable sources is usually more expensive than conventional energy, rendering investment into it unprofitable under free market, yet the role of the government in promoting these energies remains controversial. Some governments (such as the U.S. federal administration) have so far limited their efforts to subsidies for research and development in renewable energies aiming at speeding-up a technological breakthrough and thus their market maturity. In contrast, a number of European countries -as well as some U.S. states such as California- have introduced additional policy instruments to increase investments into renewable energy facilities. These additional policy instruments fall mostly into two categories: quotas and feed-in tariffs (FIT). In this paper we use a real option approach to build an empirically tractable theoretical framework to compare investor’s incentives under these two alternative policy instruments. This model is then calibrated for the case of an investment decision involving a wind energy power plant. Preliminary results from our numerical simulation show, quite unexpectedly, that quota systems, which are associated to a higher degree of uncertainty about market prices for electricity than a FIT system, make investors more, not less likely to innovate in comparison to FIT.
II. Competition & Strategy Games
R&D Investment With Inter-Firm Spillovers
In our duopoly, an irreversible investment incorporates a significant amount of R&D, so that the improvement it introduces in production processes generates a spillover lowering the second comer's investment cost. The presence of the inter-firm spillover substantially affects the equilibrium of the dynamic game: for low -- and hence realistic -- spillover values, the leader delays her investment until the stochastic fundamental has reached a level such that the follower's optimal strategy is to invest as soon as he attains the spillover. This bears several interesting implications. First, because the follower invests upon benefiting from the spillover, in our equilibrium the average time delay between the two investments is short, which is realistic. Second, we show that in case of a major innovation, an optimal public policy requires a substantial intervention in favour of the investment activity; moreover, an increase in uncertainty -- delaying the equilibrium -- calls for higher subsidization rates. Third, we find, by means of numerical simulations, that the spillover reduces the difference in the leader's and in the follower's maximum value function. Accordingly, our model can help generating realistic market betas.
Uncertainty and Competition in the Adoption of
In this paper we study, for a duopoly market, the combined effect of uncertainty, competition and “technological complementarity” on firms’ investment behaviour, in a game-choice setting where it is assumed that there is a first-mover advantage. Firms often use inputs whose qualities are complements such as computer and modem, equipment and structure, train and track, transmitter and receiver and, therefore, on such cases, investment decisions on upgrades or replacements must consider the degree of complementarity between investments. We derive analytical solutions for the investment thresholds of two firms which have the option to adopt one or two new technologies, whose functions are complements, in a context where the evolution of the saving costs that can be made through the adoption and the cost of the technologies are uncertain. We obtain analytical expressions for the value functions of the leader and the follower as well as for their optimal investment thresholds. Some of the illustrated results show nonlinear and complex investment criteria and sensitivities to expected cost savings. It might be optimal for both firms to adopt the two technologies at different times, first the technology whose price is decreasing at a lower rate and then the technology whose price is decreasing more rapidly, but the degree of complementarity between the two technologies determines the timing of such investments.
The Innovator's Dilemma Under Customer Preferences
This paper investigates the equilibrium investment policies of two different firms under customers' preferences uncertainty. The incumbent firm, which owns a superior old technology, produces merchandise that can satisfy current customers at the beginning of the investment game. The startup firm, which possesses an inferior old technology, does not capture the customers' satisfaction but it has a possibility to cultivate a new technology that can attract the customers in the future if the customers' preferences are changed. We consider two types of equilibria in our valuation model. The first one is a price equilibrium at each time point derived from the Bertrand competition. To represent customers' diversity and products differentiation we use a discrete choice model. The other one is a Markov perfect equilibrium where each firm have options to invest either in the old technology or in the new technology depending on customers' preferences which are modeled as a Markov process.
Strategic Capacity Investment Under Uncertainty
Contrary to most of the papers in the literature of investment under uncertainty we study models that not only capture the timing, but also the size of the investment. We consider a monopoly setting as well as a duopoly setting and compare the results with the standard models in which the firms do not have the capacity choice. Our main results are the following: (1) For low uncertainty values the follower chooses a higher capacity than the leader and for high uncertainty values the leader chooses a higher capacity. (2) Compared to the model without capacity choice, the monopolist and the follower invest later in a higher capacity for higher values of uncertainty. However, the leader will invest earlier in a higher capacity for higher values of uncertainty. The inverse results apply for lower values of uncertainty.
12:00 – 1:30 Luncheon Address
Flexibility in Design
1:30 - 3:00
I. Optimal Extraction & Harvesting
Optimal Investment in Extraction Capacity of
This paper extends the literature of real options and exhaustible resource economics by examining the investment decisions of an active exhaustible resource monopolist. With demand uncertainty and endogenous price dynamics, the monopolist optimally chooses both the production rates and times to build extra capacity. The capacity expansion option for such a firm is modeled as a two-dimensional option on demand shocks and remaining reserves. Using a discrete-time simulation, first the dynamics of option prices and its sensitivity to different parameters is calculated. Unlike previous literature which implies that all investments should happen in the beginning, I show that there is an optimal time to invest different from time zero. Furthermore, it is shown that the consideration of option value in investment decisions will lead the producer to choose a more conservative expansion policy and therefore causes higher prices in strong demand shock periods. Finally, the optimal production rate of the producer will change by the introduction of option feature to the problem. The findings of this paper may explain why we do not observe in practice the predictions of Hotelling rule regarding increasing prices and decreasing production rates.
Testing the Hotelling Valuation Principle: Empirical
Evidence from Canadian Oil and Gas Royalty Trusts
The Hotelling Valuation Principle (HVP) implies that the
in situ value of a unit of a non-renewable resource is equal to current price
less the cost of extraction. The required assumptions for this principle are
strongly violated in the oil and gas industry, but despite this, results from
previous research are mixed, with studies based on market data supporting the
principle, and those based on basin-aggregate data rejecting the principle. To
address problems with the data choice in previous studies, we test the HVP
using market data on Canadian oil and gas royalty trusts. Unlike previous
studies using market data for conventional oil and gas companies, our results
tend to reject the HVP and we generally find market value to be significantly
less than that predicted by the principle. The reduced value is explained by a
significantly negative response to a real option to expand (proxied by a call
option on oil and gas prices). These findings are consistent with the argument
that in the period of rising oil prices that we consider, (2000–06), the net
extraction price is high relative to its expected future growth, but production
constraints prevent firms from fully exploiting the high price.
Optimal Stochastic Harvesting with Price and Stock
Uncertainties: An Application to Radiata Pine Forest in Chile
A new stochastic harvesting model for pine even age stand was developed under wood stock geometrical logistic and price geometric Brown diffusions, with risky decision agents, for a single rotation period. The application of the model to a Chilean forest company stands increased the actual deterministic optimal cut volume in 70% average. It also showed the dominant role played by wood stock diffusion in relation to price diffusion, which had a non significant effect. Two new convergent methods for estimating the parameter of the geometric logistic diffusion from unevenly spaced and highly concentrated series under stationary and non stationary state are presented.
Valuation and Optimal Harvesting: An Application to
Eucalyptus Forestry Investment in Brazil
This paper examines a problem that is usual in investment theory: when to cut a stand of trees in an investment project of eucalyptus reforestation for cellulose production, under stochastic prices of wood. The real options approach that was used in this study has shown to be quite convenient for this type of analysis. The objective of this paper is to verify the influence of the price diffusion process in the value of a stand of trees and in the optimal cutting time. Two different processes were used, the Geometric Brownian Movement (GBM) and the process of geometric mean reversion (GMR), known as Geometric Ornstein-Uhlenbeck.
II. Environmental Policy & Sustainable Development
Choice of Alternative Environmental Policies with
Adjustment Costs under Uncertainty
In this paper, we investigate the environmental policy designed to reduce the emission of a pollutant under uncertainty. We consider that an economic agent benefits from an economic activity and suffers from the pollutant. So the agent implements the policy, which is irreversible. The costs to implement the policy are divided into the fixed cost, the proportional cost, and the quadratic adjustment cost. Further, we consider the agent has two policy options. Then, the agent must decide that which policy he implements and when he implements the policy in order to maximize his benefit. To solve the agent's problem, we formulate it as an optimal stopping problem. Furthermore, We present the numerical analysis and comparative-static analysis of the thresholds.
Investments in Energy Efficiency Improvement Under
Climate Policy Uncertainty
This paper addresses the valuation of investments in energy efficiency under uncertainty. Our aim is to adopt the viewpoint of a private investor (e.g., a power firm assessing the possibility to adopt an efficiency-enhancing technology). One driver may well be the pressing need for curbing the consumption of valuable resources, e.g., fossil fuels. As it turns out, any decrease in fuel combustion translates into lower polluting emissions. If there is a total cap on the emission of carbon, and it is coupled with a market for the emission allowances, then another driver arises in the form of a price for the new 'input' (or limited resource: the ability of the atmosphere to serve as a sink). In sum, investments in energy efficiency allow the firm to enjoy simultaneously lower bills and spared allowances. Therefore, these improvements can be justified because of savings on both the fuel consumed (e.g., natural gas) and the carbon emitted. Of course, though, actual adoption of the technology will depend on the specific conditions prevailing at the moment. In particular, the Kyoto Protocol will expire in 2012. Negotiations on the successor to KP are scheduled to conclude in December 2009 (Copenhagen), but it is still the subject of much debate. We aim to assess this type of investments in a realistic setting. There are many ways in which energy efficiency can be improved. Instead of focusing on a particular project to raise the efficiency level, we try to provide a benchmark against which a particular project (involving combustion of natural gas in a carbon-constrained environment) at any time can be checked.
Sustainable Development in Uncertain Economies
Sustainable development implies that the productive base of an economy, which is the source of well-being - and includes not only its capital assets but also its institutions- should not deteriorate from one generation to later ones. Almost all contributions in the papers exploring various concepts of sustainable development have been confined, for simplicity, to a deterministic world. The only exceptions are, to the best of our knowledge, Weitzman (1998), Marsili (2008) and some hints in ADM. Weitzman (1998) considers only the case of uncertainty in the discount factor. ADM discuss a discrete time stochastic model in a very specific and simplified setting. Marsili (2008) studies the case of a simple model with a particular multiplicative accumulation dynamics and derives the accounting prices. None of these papers apply the argument to the evaluation of policy reforms. In this paper we consider a more general setting to study the influence of uncertainty upon the welfare interpretation of comprehensive wealth and generalize ADM results in the case of uncertainty. Moreover, we extend the argument about the evaluation of policy reforms to the case of uncertainty using real options theory.
Sustainable Equilibrium Evaluation of Large-Scale
This paper proposes a project evaluation approach known as sustainable equilibrium evaluation (SEE) which can reveal the social and ecological value of outsize engineering project more adequately, by setting up an equilibrium analytical framework of project value based on the equilibrium of option game, reciprocal fairness and risk aversion, and combining the thought of sustainable development with project evaluation. The SEE approach sufficiently reflects the complexity of belief changes of connected subjects and the significance of analyzing the value of outsize engineering project, and is characterized by simple procedure and rational logic, which are necessary to the judgment of project feasibility.
3:15 MOVE TO SANTIAGO, SPAIN BY BUS
Saturday June 20, 2009
9:00 - 10:15
I. Capital Structure
Dynamic Investment and Capital Structure Under
This paper investigates the interactions between the investment and financing decisions of a firm under manager-shareholder conflicts arising from asymmetric information. In particular, we extend the manager-shareholder conflict problem in a real options model by incorporating debt financing. We show that manager-shareholder conflicts over investment policy increase the investment and default triggers and coupon payments, which lead to an increase in the value of debt and a decrease in the value of equity. Moreover, given the presence of manager-shareholder conflicts, debt financing increases investment and decreases total social welfare. As a result, there is a trade-off between the efficiency of investment and total social welfare with debt financing. These results fit well with the findings of previous empirical work in this area.
An Optimal Investment Policy in Equity-Debt Financed
Firms with Finite Maturities
In this paper we examine the effect of maturity for optimal investment policy of the firm that is financed by issuing equity and debt. Specifically, we discuss the investment timing, the firm value, the optimal leverage and coupon payment. Recently, a number of researchers have studied the interaction among firm’s investment and financing decisions under uncertainty by means of real option framework. In the literature, investment problems for a firm with growth options, that is financed with equity and debt are investigated. In most studies, in order to simplify the problem, the infinite maturity for the investment and debt is assumed. However, the assumption of the infinite maturity restricts the problem. In this paper, we examine the optimal investment policy of the firm which is financed by issuing equity and debt during a period of time.
Capital Structure, Liquidity and Transferable Human
Capital in Competitive Equilibrium
This paper analyzes how human capital and economic uncertainty affect capital structure and managerial compensation. We model a competitive industry where wealth constrained managers provide human capital that can be transferred across firms, and where equityholders give managers access to the physical assets of the firm. Equityholders and managers bargain for the firm's stochastic free cash flows. We show that the level of net debt acts as a tool to attract and retain human capital. Negative net debt occurs in volatile and human capital intensive industries. Cash holdings (or unused lines of credit) in booms serve as a costly hedge against liquidity shocks in recession. The cost of holding cash is internalized by managers, unlike the cost associated with raising cash in recession through a dilutive equity issue. We obtain simple expressions for the equilibrium payout rate and the managerial compensation rate and we show how, in recessions, they are influenced by each party's outside option.
II. Alternative Methods
Modeling Real Options Problems by Activity Diagrams
In this paper, a framework to consider the contribution of decision making and dynamic planning in the profitability of a project under uncertainty is proposed. UML activity diagrams are considered to model the different strategies (expanding, contracting, switching, abandoning, waiting, transferring, etc) than can be dynamically adopted during the execution of an engineering project whose final profitability is highly influenced by a set of uncertain variables, such as demand, costs and prices evolution or unexpected events. A method to derive a simple mathematical model from any UML activity diagram describing the strategy of execution of a project is also presented. This mathematical model can be easily implemented in a simulation environment in which the random nature of the different uncertain variables of the corresponding project and the relationships among them and the final profitability of the project can be considered. An example of application of the proposed model is shown. This example also illustrates how to model the uncertainty in demand trend by means of a stochastic Bass process. We consider that the proposed methodology allows solving some of the deficiencies found in present capital budgeting tools, such as: 1) Net Present Value or Return of Interest that are static in nature and cannot cope with uncertainty, 2) Real Options valuation that can be an obscure technique and in many cases does not allow deriving an operational strategy for guiding the project execution in real life and 3) decision analysis, which incurs in the problem of the “flaw of averages”, as it uses expected values of the different uncertain variables to calculate the profitability of the project instead of the complete probability distribution.
Compound Real Options with Fuzzy Pay-off
Compound real options are combinations of real options, where an exercise of a real option opens another real option. Compound real options are commonly found in a number of industrial projects, but are especially relevant in, e.g., research and development (R&D) where the R&D projects give the real option to research further, or to start the implementation of the results. Valuation of compound options with the most commonly used option valuation methods is often very complex and the methods suffer from a number of problems when used for valuation of real options. This paper discusses the valuation of compound real options with the fuzzy pay-off method for real option valuation and shows that the method reduces complexity of the valuation of compound real options.
Variational Approach to Optimal Stopping and Stefan
The paper deals with optimal stopping problems which arise in real options theory. We describe a variational approach to the solution of optimal stopping problems for diffusion processes, as an alternate to the traditional approach based on the solution of the Stefan (free-boundary) problem. The connection of this variational approach to smooth pasting conditions is established. We present some examples where the solution to the Stefan problem is not the solution to an optimal stopping problem. On the base of the proposed approach, we obtain the solution to an optimal stopping problem for a two-dimensional geometric Brownian motion with a non-linear payoff function. As an application we consider an optimal investment timing model taking into account tax exemptions.
10:45 - 12:00
Excessive Risk Taking and the Maturity Structure of
This paper analyses the effect of short-term debt on equityholders risk taking decisions. We show that if short-term debt limits the expropriation of debtholders by equityholders, it does not however reduce the loss in tax shields associated to a low leverage. We then examine the incentive for equityholders to increase the firm risk when debtholders rather hold the option to swap their perpetual coupon bond with short-term debt. We find that, compared to standard short-term debt, this restructuring option dramatically limits debtholders expropriation, increases leverage and reduces the loss in tax shields due of asset substitution.
A Theory of Loan Commitments Based on the Borrower's
We model an entrepreneur's choice between a loan commitment and a spot loan. The former type of loan precedes, and the latter type follows his investment timing decision. We find that the entrepreneur prefers the former when his bargaining power is small and his equity stake in the investment is large, and the latter otherwise. The spot loan yields the first-best timing when the entrepreneur behaves by maximizing security benefits, and the second-best timing when he misbehaves by diverting security benefits to extract private rents.The loan commitment inefficiently delays the investment compared to the first- and second-best benchmarks, in the region that the entrepreneur prefers it. As a result, there is demand for loan commitments in lending markets that are less than perfectly competitive, whereas in the perfectly competitive ones, spot loans always dominate loan commitments.
Skilled Labor, Immigration Option and Optimal
Investment in Human Capital
We model a highly-skilled agent who should decide how much to invest in the "global" and the "local" human capital. In this text the “global” human capital mostly refers to technical skills valued all-over the world and “local” human capital refers to those skills valuable mainly in a specific geographical or political/cultural region. We add a realistic aspect to this problem by assuming a continuous stochastic real wage ratio process between the country where the agent is currently living and adding to her human capital and another country where she can immigrate to. Exercising the immigration options requires both a lump-sum monetary cost and forgone future income of staying in the first country. In return, the agent receives the present value of income in the second country. Since the agent is rational, she considers the impact of this immigration option on the optimal rate of investment in "local" and "global" human capital and behaves accordingly at each period. We assume in this paper that the agent continues to accumulate global human capital once she immigrates. On the other hand, only a fraction of “local” human capital is valuable in the destination country and when the immigration occurs the agent loses most of the previous investments on this type of human capital and in other words all discounted future income stream generated by that. As a result she under-invests in "local" human capital and increases her investment in "global" one.
II. Location & Segmentation
Optimal Investment Timing and Location Under
We consider an investment problem such as a construction of power plants. The uncertainties, which are considered in this investment problem, are the evolution of cash flows obtained from the plant operation, and the catastrophic event, which drives the value of the project to zero due to external factors, such as earthquake. We show the model of a sequential investment as well as that of a single investment, and show the effect of the catastrophic event on the flexibility of the sequential decision by comparing the option values of the single investment and the sequential one. Additionally, in a case where both costs associated with the construction and the catastrophic event are dependent on the location, we determine simultaneously the optimal investment timing and location of the plant.
Expected Time to Invest in a New Location
We study the expected time to invest in a new location, which is a key question when it comes to the relocation problem that most companies face nowadays. For that reason we start this paper by presenting the problem in a pure economical setting, before explaining the mathematical formulation. The analysis of the problem of production units relocation for third countries, supposedly more competitive at the level of production factors and/or incentives to investment, has assumed an increasing significance in western economies, when confronted with a full array of problems induced by the fact of a growing number of companies resorting to this kind of solutions, in order to improve their competitive edge in the market. In fact, the overall movement in the sense of the growing abolition of protectionist barriers of technical and political nature has led to the creation of a more accentuated competitive environment, where a great part of economies (mainly the most industrialized) are subject to geo-economic insertion movements in widen spot. Scenarios like this, marked by the emergence of new markets, by the free circulation of capital and investments at a world scale,and by production conditions' homogeneity calls forth a scenario favourable to the production units' relocation. The overall conclusion in several studies about production units relocation is that it only reveals to be attractive when the existent comparative advantages (different conditions) between the destination and origin country overcompensate, significantly, the costs needed to support the implementation of this relocation process.
Market Segmentation Under Uncertainty
This paper proposes a general model to value different strategies to enter a market, comparing alternative segmentation strategies to the simultaneous investment in all segments. Our general model also allows demand to behave accordingly to an endogenous regime switching process, under which it can behave differently before and after investment. We show how uncertainty, revenue and investment costs of each segment influences the choice between sequential or parallel investment, as well as the optimal path. The model also offers some insights for the valuation of growth options.
1:30 - 2:45
I. Theoretical Issues
Redevelopment of Real Property Assets
Redevelopment option value, like port wine, usually improves with the age of the property. Both property quality and rent per quality characteristics are uncertain, as user perceptions and requirements change over time. We reformulate and extend models developed by several authors especially Williams (1997), providing alternative (mostly analytical) solutions, incorporating both quality and rental uncertainty. Our solutions do not have restrictions on property bubbles or hopeless redevelopments, and cover both single and multiple redevelopment possibilities. We compare the results of the increasingly complex models, and illustrate application to Canary Wharf. While we believe our models are feasible, extensions might consider more realistic mixed uses and sequential redevelopments, as well as further work in estimating expected quality and rent drift and volatility, along with required redevelopment returns.
Real Option Pricing with Mean-Reverting Investment
and Project Value
In this work we are concerned with real option prices when the project value and the investment value undergo a mean-reverting stochastic dynamics. We consider the question of finding the dynamics for which an investment trigger curve, based on the ratio, can be determined. For a particular class of mean-reverting processes, we show that the investment frontier can be represented by such a ratio. In particular, the dynamics of the ratio is also mean-reverting. For more general dynamics, which might include jumps, the above reductions do not seem to be possible, and a Fast Fourier Stepping Method is discussed instead. 17
Manufacturer Capacity Ordering and Financial Subsidy
Policy to Risky Suppliers
The risk of supply disruptions due to suppliers' financial problems plays a prominent role in manufacturers' risk portfolios. Even large suppliers (e.g. Delphi) could file for bankruptcy, and manufacturer's actions, such as financial subsidies to the suppliers, affect profoundly suppliers' financial health. Using a dynamic, stochastic, periodic-review model of the manufacturer's joint capacity reservation and financial subsidy decisions and a firm-value model of the supplier's financial state, this paper addresses the following questions: What is the optimal joint capacity ordering and financial subsidy policy for the manufacturer? Must subsidy and capacity ordering decisions be made jointly? How good are the recommendations from the traditional procurement models, which ignore the benefits of controlling the supplier's financial state through subsidies? The paper presents general assumptions that allow the manufacturer to make ordering decisions independently from subsidy decisions and investigates interactions between ordering and subsidy decisions when these assumptions are violated. Conditions are presented for the optimal subsidy policy to have a "subsidize-up-to" structure and for the optimal ordering decisions to be newsvendor fractiles.
II. Investment, Divestiture & Abandonment
Investing Timing and Foreclosure: An Application to
Buy To Let Real Estate Property in the United Kingdom
We model investment growth options and default/foreclosure options open to a landlord who has purchased a property financed by a mixture of debt from a lender (building society/bank) and their own equity, by combining two aspects of finance literature i.e. that of irreversible investment and debt pricing/capital structure. Current real estate research into optimal mortgage lending usually starts with stochastic house price process but we start with stochastic rental income. Model parameters, such as bargaining power, taxation levels, asset volatility and default dead weight costs common to debt pricing/capital structure models are extended by the inclusion of a letting agent management fee and lender’s loss severity percentage. The model is applied to realistic UK “Buy to Let” (BTL) data. Lower landlord tax bands lowers both entry and renegotiation thresholds of his growth and default options. Higher rental income volatility increases entry and renegotiation thresholds. The potential of increased loan loss severity will cause the entry-level threshold to increase only in the case where the lender’s negotiation position is anticipated to be weak. The letting agent’s management fee influences both the landlord’s growth option and default option. Finally the (likely) global effects of the UK government’s macro economic policies, directed at interest rate manipulation and lender support are shown, in the context of this model, not to have a significant effect on encouraging new BTL investment or mitigating default/foreclosure due to the large influence of (recent) increased rental income volatility. Rather micro economic policies, perhaps supported by the house building industry and letting agents segment, directed at stabilising or mitigating rental income volatility may be more effective in influencing landlords and lenders growth options.
Partial Divestment and Firm Sale under
This paper studies optimal divestment policy of an investor in a firm that may partially and gradually divest its capital or sell the whole firm at once. Partial divestment offers greater flexibility while a whole-firm transaction provides a price premium. We show that, if the price premium includes both a fixed and a proportional component, a large firm optimally starts to divest partial capital before choosing to sell the whole-firm. Full-firm divestment is preferable over partial divestment with higher profit volatility, in more declining markets and if capital is less industry-specific.
A Multi-Cycle Two-Factor Model of Asset Replacement
The aim of this article is to analyse the asset replacement problem in the perspective of optimal replacement time given a certain tax environment and depreciation policy. Using a real options approach, our model minimises current operation and maintenance costs and permits a new valuation of the replacement flexibility under a multi-cycle environment. The innovation on the valuation process comes from adding an autonomous salvage value factor. Results from partial differential equations reveal relevant differences from those observed in one-factor models, specifically in optimal replacement levels and in the non-monotonous effects of salvage value variation. This paper provides enhancements to existing literature on equivalent annual cost by formulating a cost-minimisation problem conditioned by autonomous salvage value dynamics, and it contributes to Real Options literature by introducing a salvage value factor in the valuation model.
3:15 - 4:30
I. Computational Applications
Valuation of a Municipal Wastewater Plant Expansion:
An Application to a High Growth Resort Area in Canada
The municipal water and wastewater sector is considered to be the most capital intensive industrial sector. Naturally, any methodology that has the potential to improve capital allocation decision making, has the potential to make a positive financial contribution to this sector. Most managers are aware of the power of calculating the Net Present Value (NPV) of an investment decision using Discounted Cash Flows (DCF). The problem with DCF based NPV analysis is that the inherent value of future project options is not modeled. In this study, we consider a small resort-based municipality faced the question of how big to make their new wastewater treatment facility to meet the expanding demand of 10% growth in the number of new residential connections to the wastewater treatment infrastructure. Since a significant number of new dwellings are second “weekend” homes, the planners felt strongly that growth rates were tied to the strength of the market index. Here we set the model framework for considering optimal plant size based on correlation assumptions of municipal growth to the market index. The model takes on the form of an Asian option. The results show that the greater the (assumed) correlation, the smaller the required plant size. Penalty costs associated with not building a large enough plant are hedged in the market. This paper sets that basis for future analysis of staged plant expansion analysis.
Valuing Multivariate Contingent Claims With
When assets prices jointly follow a diffusion process with catastrophic jumps we explore cases where the problem can be simplified and treated as if they follow a diffusion process. In the option to exchange two financial assets, the existence of a catastrophic event that affects both simultaneously, does not affect option price. We also demonstrate a Markov-Chain numerical method and apply it in the study of R&D. We see that conventional wisdom does not hold, and the value of the option on the best of several assets can be high even if returns are positively correlated.
Assessing Least Squares Monte Carlo for the Kulatilaka-Trigeorgis
We assess the applicability of (Longstaff and Schwartz, 2001) Least Squares Monte Carlo method (LSMC) to the General Real Options Pricing Model of (Kulatilaka and Trigeorgis, 1994) (KT). We propose some moment matching methods to get comparable results from KT model under different underlying stochastic processes for both LSMC and multivariate lattice methods. We study LSMC under different stochastic processes, namely: GBM, up to three dimensions, and models 1, 2 and 3 in (Schwartz, 1997). Each LSMC application has been appropriately benchmarked by lattice methods. We explore empirically a generalization of proposition 1 page 124 in (Longstaff and Schwartz, 2001) with respect to the number of discretization points K, of basis functions M, and of the number of simulated paths N for an individual estimate. Then, we study the speed precision tradeoff of LSMC when applied to the KT model with respect to the last two parameters just mentioned. Finally, we show the small and large sample statistical properties of LSMC estimates when these are replicated R times. We show how to make statistical inference on them, providing a practical application of proposition 2 page 125 in (Longstaff and Schwartz, 2001). We conclude that LSMC can be conveniently used to estimate KT models in both univariate and multivariate frameworks, providing quick, although slightly biased estimates when some moment matching methods are adopted, an adequate number of replications is performed and the right least squares parameters are honed to choose consciously the appropriate trade off between precision and speed.
II. Conceptual Models
Real Options, Uncertainty and Comparative
The purpose of this paper is to analyze the influence of uncertainty on the value of real options while allowing for a possible change in the value of the underlying asset. We show that the proposition of a strictly positive influence of uncertainty does not hold, if the value of the underlying asset changes due to a variation of the standard deviation. Only if the underlying risk is unsystematic or the binding relation between risk and return is neglected, the strictly positive effect of uncertainty can be retained. In all other cases, the influence becomes ambiguous. In addition, we discuss the consequences of our results on a more economic level to convey an understanding of when the procedure dealt with would be indicated.
Investment Hysteresis and Hitting Time for
Mean-Reverting CIR Diffusions
Using the so-called mean-reverting square-root process of Cox et al. (1985b) we generalize the work of Dias and Shackleton (2005) by introducing the mean reversion feature into the economic hysteresis analysis under stochastic interest rates and show that such issue highlights a tendency for a widening effect on the range of inaction,though both thresholds have risen when compared with the no mean-reverting case. In addition, using the work of Linetsky (2004) we compute the hitting time densities in order to have an idea of how long does it take for a current interest rate to revert and hit the investment thresholds that would induce idle firms to invest.
Valuing Modularity As a Real Option
We provide a general valuation approach for capital budgeting decisions involving the modularization in the design of a system. Within the framework developed by Baldwin and Clark (2000), we implement a valuation approach using a numerical procedure based on the Least Squares Monte Carlo method proposed by Longstaff and Schwartz (2001). The approach is accurate, general and flexible.
4:40 – 5:30
Panel Discussion: Current State, Challenges and Future Prospects
K.J.M. Huisman (Tilburg U., Netherlands)
Sunday, June 21, 2009
Bus returns to Braga, leaving Santiago at 11:00 am (Spanish time) and going through the City of Culture. It arrives in Braga at approximately 2:00 pm (Portuguese time)
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