About the Conference

Past Papers


Annual International Conference on Real Options: Theory Meets Practice

14th Annual International Conference
June 16-19, 2010

Rome, Italy

Organized by

Real Options Group
Real Options Group

Conference Program

Thursday, June 17, 2010


Welcome & President's Address

Lenos Trigeorgis, U. Cyprus & ROG

Patent Leveraging Strategies: Fight or Cooperate?

(with Francesco Baldi, Luiss U., Italy)



Chair: Lenos Trigeorgis, U. Cyprus


Integrating Resourced-Based View and Real Options for Investments in Outside Opportunities

Nalin Kulatilaka, Boston U., United States

Laura Toschi, U. Bologna, Italy

There is a growing trend by established firms to use a multitude of External Corporate Venturing (ECV) mechanisms (alliances, partnerships, joint ventures, acquisitions, licensing agreements and investments in corporate venture capital) to acquire external innovations. In this paper, we develop a framework within which firms choose ECV mechanisms that are best aligned with characteristics of the target company. More precisely, we investigate the effect of relatedness and uncertainty on governance mode choices by combining the Resource-based View of the firm and Real Options Theory. We propose a bi-dimensional matrix to show under which conditions of relatedness and uncertainty corporations choose among corporate venture capital, strategic alliance, joint venture and acquisition. We suggest that: (a) When the level of relatedness between the corporation and the target company is high and the level of uncertainty surrounding the target company is low, corporations are more likely to choose acquisitions as mechanism of ECV. (b) When both the levels of relatedness and uncertainty are high, corporations are more likely to choose strategic alliances (and corporate venture capital as second alternative). (c) When the level of relatedness is low and the level of uncertainty is high, corporations are more likely to choose corporate venture capital (and strategic alliances as second alternative). (d) When both the levels of relatedness and uncertainty are low, corporations are more likely to choose joint ventures as mechanism of ECV. Finally, we present a dynamic perspective to assess how these different forms of ECV transit over time, once part of uncertainty is resolved and a certain level of familiarity with the new knowledge is achieved.


Real Options and Signaling in Strategic Investment Games

Takahiro Watanabe, Tokyo Metropolitan U., Japan

This paper investigates an investment game with an incumbent and an entrant for optimal entries into a new market. The profit flows of the market involves two uncertain factors. One factor is determined at the beginning of the game and the only incumbent can observe it as private information. The other factor is described by a stochastic process for revenue flows which is common to both firms. Each firm decides the timing of the investment for the entry of the market. I assume that the profit of the incumbent is relatively larger than that of the entrant, hence the incumbent invests earlier than the entrant. If the earlier investment by the incumbent reveals the information about high demand, the entrant would accelerates the timing of the investment by observing the incumbent's timing of the entry and it reduces the monopolistic profit of the incumbent. Thus, the incumbent knowing the high demand may delay the timing of the investment to hide the information strategically. I characterize the signaling effect by a weak perfect Bayesian equilibrium and investigate the values of both firms.


Innovation Evidence

Chair: Raffaele Oriani, Luiss U., Italy


Risk Dynamics and Stock Trading Behavior around New Product Introductions

Achim Himmelmann, Tech U. Darmstadt, Germany

Dirk Schiereck, Tech U. Darmstadt, Germany

We analyze the relationship between new product introductions, trading activity, and systematic risk changes. The analysis is placed within a real options framework in which new product introductions are associated with the exercise of a real option. Using a unique hand-collected data set on new drug ap-provals, we find opposing results to previous work. Trading activities change after new product an-nouncements and stock become more liquid. However, we have no evidence on changes in systematic risk. After adjusting for potential biases caused by increased leverage and frictional trading, estimates for systematic risk are indifferent before and after the new product announcement. Our results have implications for the firm’s cost of capital and internal investment decisions. Investors’ required return remains unchanged and cost of equity for technological-intensive companies is invariant to new product intro-ductions and the exercise of corresponding real options.


Explaining the Remuneration Structure of Patent Licenses

Maria Isabella Leone, Luiss U., Italy

Raffaele Oriani, Luiss U., Italy

The design of an appropriate remuneration structure is one of the crucial aspects of patent license negotiation. However, with few exceptions, literature about licensing has paid scarce attention to the determinants of the contractual remuneration structure. Moreover, the licensee’s perspective has been often neglected. The aim of this paper is to shed new light on the variables affecting the upfront fee that the licensee is willing to pay to enter the license. Consistently with real options theory, we consider the initial fee paid by the licensee analogous to the premium of an option to commercialize the patented technology in the future. As such, the upfront fee should be positively affected by market uncertainty and technological potential. We empirically test our hypotheses on an original sample of 124 patent licenses, finding support to our hypotheses.


Empirical Evidence

Chair: Raffaele Oriani, Luiss U., Italy


Equilibrium of a Real Options Bargaining Game: Evidence from Natural Gas

Yuanshun Li, Ryerson U., Canada

Gordon Sick, U. Calgary, Canada

This paper empirically examines the equilibrium of firms’ investment decision given a context in which firms’ output price and production volume are uncertain, firms may choose to invest cooperatively or competitively, and there are economies of scale (network effects). In this setting, interacting firms play a real option bargaining and exercise game under incomplete information. The results from duration analysis show that output commodity prices have a negative effect on the duration of investment lag and the network effect has an positive effect on the duration of investment lag. In addition, the logit model results show that the real option exercise price has a negative effect on the probability of cooperation, and the network effect has a positive effect on the probability of cooperation.


Multinationality, Growth Options and Real Options Capability: Impact on Firm Performance

Sophocles Ioulianou, U. Cyprus, Cyprus

Lenos Trigeorgis, U. Cyprus, Cyprus

Tarik Driouchi, Cranfield U., United Kingdom

We examine the joint impact of multinationality, growth options and real options capability on firm performance. Based on a sample of all US listed firms for the ten-year period 1996-2005, we show that when a firm’s growth options and its degree of real options capability are taken into consideration, multinationality has a positive significant impact on firm performance. We confirm a significant positive impact of both operating and strategic flexibility on firm value and that the impact of multinational flexibility is higher for firms with a higher degree of real options capability in place. The more capability a firm has in implementing its real options, the better its performance.


Leaders and Followers in a Hot IPO Market

Ismail U. Gucbilmez, Lancaster U., United Kingdom

Shantanu Banerjee, Lancaster U., United Kingdom

Grzegorz Pawlina, Lancaster U., United Kingdom

We explain why some private firms lead a hot IPO market by going public early, while others follow by delaying their IPOs until late in the same market. In our model, there is uncertainty about the future state of economy and going public is valuable only in the good state of economy. Consequently, firms have to decide whether to go public now or to wait until the state of economy becomes known. Bad firms always wait. If the economy turns out to be good (bad), they go public (remain private) and incur (save) issuing costs. Good firms, which can increase their probability of success by pre-committing to invest, may prefer to go public immediately. They, however, have to underprice their shares, since bad firms have an incentive to mimic them otherwise. We find evidence for our arguments in the U.S. IPO market: Early IPOs of a hot market are underpriced more severely on average, but they experience higher growth in sales, assets, EBITDA, and capital expenditure. Moreover, their shares outperform the market up to nine months after their issues, while those of late IPOs underperform the market from the start.


Options & Games: Overview

Chair: Kuno Huisman, Tilburg U., Netherlands


Reconciling Real Option Models: Incorporating Market and Private Uncertainties

Kelsey Barton, U. Toronto, Canada

Yuri Lawryshyn, U. Toronto, Canada

Real option analysis is a new paradigm in corporate and project appraisal, a departure from traditional, static appraisal; it bridges concepts of valuation and strategic planning. In literature several techniques designed for practitioners exist, but there is discrepancy in their underlying assumptions, mechanics and applicability. Within this paper, a review of approaches targeted towards practitioners is included, and a novel method of incorporating market uncertainty proposed. Cash flows may range in their degree of correlation between a representative stock, or stock index. A partial differential equation for a claim contingent on the cash flows is derived, and may be approximated by tree methods. Options are introduced at discrete decision nodes, and the affect on underlying net present value of the project realized. An example scenario demonstrates this approach, and compares valuations to other methods.


Real Options Investment Games: A Review

Alcino Azevedo, Hull U., United Kingdom

Dean Paxson, U. Manchester, United Kingdom

The combination of game theoretic analysis with the real options theory has been an active area of research in the last decade. Game theory has been focus of great attention in the academic field over the last decades and has influenced the development of a wide range of research areas from economics, biology and mathematics to political science. Real options theory, on the other hand, emerged in the eighties as a valuation technique, especially appropriate for investments with high uncertainty, and is today taught in most of the universities’ MBAs and Postgraduate courses. Although not always explicit, game theory concepts have been used in a growing number of recent real options models. The attractiveness of the researchers for modeling competitive investment decisions by mixing concepts from both theories is because an investment decision in a competitive market can be seen, in its essence, as “game” between firms, in the sense that in their decision firms implicitly take into account what they think it will be the other firms’ reactions to their own actions, and they know that their competitors think the same way. So, as one of the game theory’s goals is to provide an abstract framework for modeling situations involving interdependent choices, a merger between these two theories appears to be a logic step to do. In this paper, we review an extensive number of competition real options models and discuss some technical details underlying the combined real options and game theory framework currently used in the derivation of the firms’ value functions, investment thresholds and the study of the implicit investment game equilibrium. In the Appendix, we present a summary of the game theory aspects underlying each of the papers reviewed.


Strategic Investment Under Uncertainty: An Overview

Benoit Chevalier-Roignant, WHU, Germany

Christoph M Flath, WHU, Germany

Huchzermeier Arnd, WHU, Germany

Lenos Trigeorgis, U. Cyprus, Cyprus

Research contributions providing insights at the intersection of real options analysis and industrial organization have become numerous in the recent decade. In the present paper, we provide an overview of the key subjects addressed in this literature aiming to both categorize and relate contributions in this stream of research. We highlight managerial insight obtained from these models with respect to the type of competitive reaction, the manner in which information is revealed over time, the nature of the competitive advantage (first vs. second-mover advantage), firm heterogeneity, capital divisibility and the number of competing firms.


Keynote Address

John Kensinger, U. North Texas, USA


Friday, June 18, 2010



Research & Development (Track I)

Chair: Grzegorz Pawlina, Lancaster U., UK


Evaluating Pharmaceutical R&D under Technical and Economic Uncertainty

Luigi Sereno, U. Pisa, Italy

Enrico Pennings, Erasmus U. Rotterdam, Netherlands

This study sets up a compound option approach for evaluating pharmaceutical R&D investment projects in the presence of technical and economic uncertainties. Technical uncertainty is modeled as a Poisson jump that allows for failure and thus abandonment of the drug development. Economic uncertainty is modeled as a standard diffusion process which incorporates both up-and downward shocks. Practical application of this method is emphasized through a case analysis. We show that both uncertainties have a positive impact on the R&D option value. Moreover, from the sensitivity analysis, we find that the sensitivity of the option with respect to economic uncertainty and market introduction cost decreases when technical uncertainty increases.


R&D Investment and Technology Adoption

Verena Hagspiel, Tilburg U., Netherlands

Kuno Huisman, Tilburg U., Netherlands

Cláudia Nunes, Instituto Superior Técnico, Portugal

We study a model of technology adoption. The firm's profit is depending on the technology that it uses. The firm holds the option to upgrade its current technology with a new one. Technology progress is modeled with a Poisson process. The firm can either rely on the external R&D market or it can setup its own R&D centre. The arrival rate of new technologies in the external R&D market is constant and given. Whenever the firm chooses to setup its own R&D centre it can optimaly set the arrival rate of the new technologies. However, the setup costs are increasing in the selected arrival rate. We identify the parameter values for which its optimal for the firm to setup its own R&D centre and for those parameter values we determine the optimal arrival rate. Moreover, we determine the optimal technology adoption trigger in all situations. We end the paper with comparative static results.


Assessing Alternative R&D Investments under Uncertainty

Motoh Tsujimura, Ryukoku U., Japan

In this paper we examine a firm's R\&D investment problem under uncertainty. Suppose that the firm's problem is to maximize expected total discounted profit. Further, there are two kinds of technologies distinguished by the level of productivity and their associated costs, such that one technology increases quantity of output more than alternative technology. To solve it, we formulate it as an optimal stopping problem.


Valuing Energy & Power Investments (Track II)

Chair: Gordon Sick, U. Calgary, Canada


Valuing Investments to Enhance Energy Efficiency

Luis M Abadie, Basque Centre for Climate Change, Spain

Jose M Chamorro, U. Basque Country, Spain

Mikel Gonzalez-Eguino, Basque Centre for Climate Change, Spain

This paper deals with the optimal time to invest in an energy efficiency enhancement. There is a broad consensus that such investments quickly pay for themselves in lower energy bills and spared emission allowances. However, investments that at first glance seem worthwhile usually are not undertaken. Our aim is to shed some light on this issue. In particular, we try to assess these projects from a financial point of view so as to attract sufficient interest from the investment community. We consider the specific case of a firm or utility already in place that consumes huge amounts of coal and operates under restrictions on carbon dioxide emissions. In order to reduce both coal and carbon costs the firm may undertake an investment to enhance energy efficiency. We consider three sources of uncertainty: the fuel commodity price, the emission allowance price and the overall investment cost. The first one is assumed to follow a mean-reverting process while the last two are governed by geometric Brownian motions. The parameters of the coal price process and the carbon price process are estimated from actual futures prices. The numerical parameter values are then used in a three-dimensional binomial lattice to assess the value of the option to invest. As usual, maximising this value involves determining the optimal exercise time. Thus we compute the trigger investment cost, i.e., the threshold level below which immediate investment would be optimal. A sensitivity analysis is also undertaken. Our results go some way into explaining the so-called energy efficiency paradox.


Valuing Base Load Coal-Fired Power Plant Investment

Jurica Brajkovic, U. Southampton, UK and Energy Institute Hrvoje Pozar, Croatia

Using real options framework I analyze investment in base load coal fired power plant. Analysis is done using real options framework and assuming option to invest is a perpetual option. The paper has two objectives. First one is to determine the most appropriate stochastic process to model evolution of dark spread prices. Second goal is to asses how does the choice of stochastic processes affect investment decision within the real options framework.


Investment Timing, Capacity Size, and Technology Choice for Power Plants

Ryuta Takashima, Chiba Institute of Technology, Japan

Afzal Siddiqui, U. College London, United Kingdom

Shoji Nakada, U. Tokyo, Japan

Deregulation of electricity industries has created wholesale markets with uncertain prices and offered greater exibility to investors to make decisions. In this paper, we consider the problem of a typical investor who has discretion over not only the timing, but also the sizing of a new power plant. The interaction between these two types of managerial exibility may be addressed analytically using the real options approach. Since an investor may also have discretion over technology choice, we allow for an investment opportunity in two mutually exclusive projects with embedded timing and sizing options. Via numerical examples, we illustrate how an investor may make decisions about timing, sizing, and technology choice. Sensitivity analyses to key parameters also highlight the intuition for how decisions are made.


Innovation & Technology Adoption (Track I)

ChairKirill Zavodov, U. Cambridge, UK


Valuation of N-stage Investments under Jump-diffusion Processes

Luigi Sereno, U. Pisa, Italy

Rainer Andergassen, U. Bologna, Italy

In this paper we consider N-phased investment opportunities where the time evolution of the project value follows a jump-diffusion process. An explicit valuation formula is derived under two different scenarios: in the first case we consider fixed and certain investment costs and in the second case we consider cost uncertainty and assume that investment costs follow a jump-diffusion process.


Optimal Technology Adoption when the Arrival Rate of New Technologies Changes

Verena Hagspiel, Tilburg U., Netherlands

Our paper contributes to the literature of technology adoption. In most of these models it is assumed that after the arrival of a new technology the probability of the next arrival is constant. We extend this approach by assuming that after the last technology jump the probability of a new arrival is not constant. New technology becomes available according to a Poisson process. The firm can adopt new technology by paying a sunk cost. Deciding about the optimal investment strategy the firm has to take into account that the intensity of the arrival rate can take two values. Right after the arrival of a new technology the intensity equals lambda_1 and this level switches to lambda_2 if no new technology arrival has taken place in a certain period after the last technology arrival. In our paper we compare the results of our model to the results of the standard model with constant arrival rate. Furthermore, we investigate the changes in the timing of the firm's technology adoption for different parameter values of the intensity rates. Particularly interesting is the case where after a new arrival the firm knows for sure that no new technology will arrive for a certain period of time, i.e. lambda_1 = 0. Thinking of electronical innovations it is very natural for a producer that after she recently introduced a new product at the market she will let some time pass for a product update. A consumer who wants to buy a MP3-player knows that after Apple has released a new IPod version, the company will not come up with a new product soon. In a next step we add uncertainty regarding the moment of the change of the arrival rate. So that the firm does not know when the arrival probability changes.


Functional Dependencies in Vertical Industrial Structures and Readiness of Complementarity in Innovation

Kirill Zavodov, U. Cambridge, United Kingdom

Kanak Patel, U. Cambridge, United Kingdom

We model investment under uncertainty in presence of complementarity with and without spillover effects. The associated functional dependence structure may create a low-level equilibrium trap. We derive efficient sharing (inter-firm transfer) arrangements that help resolving the trap.


Switching Options Applications (Track II)

Chair: Sigbjørn Sødal, U. Agder, Norway


Rainbow Options in Co-integrated Markets

Jörg Dockendorf, U. Manchester, United Kingdom

Dean Paxson, U. Manchester, United Kingdom

This paper develops a continuous real option model on the best of two commodities when their price spread follows an arithmetic mean-reverting process. The co-integration of the two variables effectively allows the complexity to be reduced from two sources of uncertainty to only one by focusing on the spread, which is why the model can also be applied to continuous entry/exit problems on a single mean-reverting variable. We provide a quasi-analytical solution for valuing this real rainbow option and the trigger levels when to switch between the two operating modes by incurring a switching cost. All parameters of our solution are estimated from empirical data and consistent risk-adjusted discounting is applied. We apply the theoretical model to value a polyethylene plant based on the spread between polyethylene and ethylene. The spread is shown to be stationary and the parameters of the stochastic process are estimated by OLS regression and tested for validity. The sensitivity analysis reveals important implications for the investment timing and operation decisions of investors in a flexible plant, both depending on the extent of mean-reversion in the value-driver.


The Dynamics of Outsourcing and Integration

Bart M. Lambrecht, Lancaster U., United Kingdom

Grzegorz Pawlina, Lancaster U., United Kingdom

João C.A. Teixeira, U. Azores, Portugal

This paper models the choice between outsourcing and integration for a firm that faces price uncertainty in both the upstream and downstream market. The firm can outsource the production of some input at an exogenous, stochastic price or it can produce the input internally at an average cost of production that is U-shaped. Up to three different production regimes can arise: pure outsourcing, pure integration, or a mixed regime where the firm produces the input internally up to some threshold quantity, and outsources all production in excess of this threshold. Investment in costly capacity narrows the range of output prices over which internal production is optimal because integrated production is more capacity intensive than outsourcing. The amount of capacity installed is determined -- among other factors -- by the cost of capital, the unit cost of capacity and the fraction of the time that the marginal unit of capacity is expected to be utilized. Switching back and forth between outsourcing and integration in response to demand shocks can be an efficient way for the firm to make optimal use of its capacity and to minimize production costs.


Switching in Shipping Markets under Extreme Uncertainty

Sigbjørn Sødal, U. Agder, Norway

Roar Adland, Clarksons, United Kingdom

International shipping is a capital intensive industry that is characterized by high uncertainty and often highly irreversible investments. This makes search for market imperfections and optimal timing of investment a key issue for ship owners. Seldom or hardly ever in peacetime have the major bulk markets that dominate the shipping business been as volatile as during the decade leading up to the ongoing economic crisis. The recent development could make the understanding of optimal investment timing even more important in the future. The objective of the paper is to use the recent development to shed light on the potential for arbitrage gains by well-informed market agent and to deepen the understanding of investment behaviour in shipping markets during or close up to a crisis. This issue is explored mainly by investigating opportunities for arbitrage for a capital-constrained ship owner in the bulk markets. Using continuously updated, market based switching costs related to purchase and sale across various market segments, and Ornstein-Uhlenbeck estimates of freight income differentials, the optimal trigger points for investment and disinvestment are calculated for a standard real options entry-exit model and compared to the observed market behaviour. Information providers like Clarksons have been forced to suspend the reporting of several market prices during the crisis. Part of the discussion therefore must take the form of a what-if analysis, answering questions like what the theoretical market price must have been if competition were to be perfect at a certain time. The paper builds on previous work by Sødal, Koekebakker and Ådland (Applied economics 2009, vol 41 iss 22, pp. 2793-2807).


Competition Games (Track I)

Chair: Artur Rodrigues, U. Minho, Portugal


Competition, Uncertainty, and Corporate Cash Holdings

Marco Della Seta, Tilburg U., Netherlands

This work investigates the effects of competition on firms' cash holdings. We build a differentiated Cournot model where the intensity of competition depends on the degree of product substitutability. Firms are subject either to shocks (called common) that move their profitability in the same direction or shocks (called idisyncratic) that move profitabilities in opposite direction. Access to financial markets is imperfect and firms hold cash reserves to avoid inefficient liquidation. We find that the nature of uncertainty plays a key role to determine the cash policies. When shocks are common, the level of cash reserves either decreases or remains unaffected with respect to the degree of product substitutability. On the contrary, cash holdings increase with the intensity of competition when shocks are idiosyncratic. This happens because, with idiosyncratic shocks, more intense competition increases the volatility of firms' profits. Larger volatility implies that for the firms the option to remain alive becomes more valuable so that it is optimal to wait longer before to abandon the market. For this reason, firms hold a larger amount of liquidity reserves to survive periods of distress.


Investment, Exogenous Entry and Expandable Markets Under Uncertainty

Paulo Pereira, U. Porto, Portugal

Artur Rodrigues, U. Minho, Portugal

This paper proposes a real options model for a duopoly faced with an exogenous entry of a third competitor that can expand the market. Usually market positions appear as a stable status quo situation. Competition exists while the dupoloy places are available and both firms fight for them, but after the entry of the follower, no more competitive damages or benefits are considered. The proposed model tries to modify this picture by considering the hypothesis of a third entry in the market, which depends upon an investment that can produce a market expansion. The likelihood of entry, its impact on the first firms’ market shares and the dimension of the expansion influences the behavior of the first two players.


Market Entry Sequencing under Uncertainty

Benoit Chevalier-Roignant, WHU, Germany

Arnd Huchzermeier, WHU, Germany

Lenos Trigeorgis, U. Cyprus, Cyprus

At the early stages of industry development a number of fi rms, though not yet operating in the market, have typically identi fied the opportunity to enter but wait for the market to be sufficiently large (to offset the market-entry cost). When the market is not protected by exogenous entry barriers, this opportunity may be available to a large number of companies - characterizing a shared investment option - which may have trouble identifying other potential entrants. Starting with Leahy (1993), incremental capital investment in competitive settings have been extensively examined. In contrast, lumpy investment problems have been generally studied in a duopoly setting but rarely in oligopolies with more than two fi rms, with the notable exception of Bouis, Huisman, and Kort (2009). In the present paper, we bridge this research gap and assert that in oligopolies the market entries (lumpy investments) take place in sequence. When firms ignore their rivals' move - as in oligopolies with a large number of fi rms - investors acting in their own interest enter at the time a central planner would impose them to. By contrast, when firms have clearly identifi ed other would-be entrants and can observe and react to their rivals' move before their own market-entry decisions (as, e.g., in duopoly), we show that market entries occur in sequence though not in a socially-optimal manner. More information about rivals' play, thus, lead to social loss.


Infrastructure Investment (Track II)

Chair: Yuri Lawryshyn, U. Toronto, Canada


Valuing Hydrogen-based Infrastructure Investment with Multiple Sources of Uncertainty: An Application to Transportation System in Netherlands

Ye Li, Utrecht U., Netherlands

Peter-Jan Engelen, Utrecht U., Netherlands

Clemens Kool, Utrecht U., Netherlands

Tom Poot, Utrecht U., Netherlands

The shift from a fossil-fuel to a hydrogen based transportation system requires sufficient supporting infrastructures. This paper develops a real option model to investigate the value of this investment opportunity which is able to handle the multiple uncertainties from market, political and technological aspects. The uncertain market and political uncertain factors will be transformed into a project value function which is incorporated with Geometric Brownian Motion and Jump process. Unlike the conventional jump-diffusion model, the jump in our model is designed as strictly positive to account for any favorable policy to support hydrogen fuel-cell and will only work on the drift term for a direct contribution to the underlying value. With explicit discounting of the risk of technical failure at each phase, stochastic project variation is an input of the real option framework and the sequential nature of hydrogen infrastructure investment will be interpreted as a chain of expanded call options. Moreover, we include the learning effect that will induce the cost reduction into the valuation. It appears that the early stage of infrastructure adoptions has a significant strategic value for the locked in future investment opportunities, which are dominated by the increasing power of push from technical learning, political impact and market uncertainty. However, this significance may most likely be offset due to a lower chance of investment in each stage successive of moving towards commercialization.


Investment with Government Subsidies and Cost Contingency: The Case of Build-Operate-Transfer (BOT) Toll Road

Kanak Patel, U. Cambridge, United Kingdom

Phuong Doan, U. Cambridge, United Kingdom

We model a Build-Operate-Transfer (BOT) toll road project as a portfolio of options within a framework of subsidies agreement with local government, and under the effects of stochastic costs contingency and revenue uncertainty. Cost overrun and revenue uncertainty occur in both construction and operation phases of the project, while government guarantees are provided in the operation phase to subsidize the uncertain income. Our proposed model suggests that effects of cost contingency and revenue uncertainty on the value of the option portfolio are immense: the expected construction costs to completion must reduce remarkably to ensure that the project is completed within the allocated construction budget, or the construction budget must increase remarkably to meet additional cost requirements when construction cost jumps. The model also tests net income guarantee - an alternative government subsidy policy - in which guarantees from the local government involve both revenue and cost uncertainties so that cost overrun risk in such a BOT project is actively shared between the two parties. With the application of net income guarantee, value of the investment program increases and the firm - the concessionaire - is more encouraged than when revenue guarantees are provided to undertake such a risky BOT project, even with higher projected construction cost to completion.


Modular Expansion of a Wastewater Treatment Plant

Yuri Lawryshyn, U. Toronto, Canada

Sebastian Jaimungal, U. Toronto, Canada

We consider a municipality faced with the question of how big to make their new wastewater treatment facility to meet the demand of 10% expected growth in the number of new connections. Previously, we developed a real options framework for determining optimal plant size and showed that the model takes on the form of an Asian option. Furthermore, it was shown that if the connection rate growths are closely correlated with the market growth, then the penalty costs associated with having insufficient capacity to treat the wastewater can be effectively hedged, significantly reducing overall expected costs. In this study, we introduce an approximate analytical solution and optimize the plant size of a staged / modular expansion. Based on the given construction cost estimates, we show that a staged expansion has a minimal (expected) savings when connection growth rates are closely correlated to the market growth rates. However, as the correlation decreases to zero, or, alternatively, no attempt is made to hedge the penalty costs, a staged expansion has an expected savings of 20%.


Mergers & Acquisitions (Track I)

Chair: Francesco Baldi, Luiss U., Italy


Valuing M&A Synergies as (Fuzzy) Real Options

Jani Kinnunen, Åbo Akademi U., Finland

This paper views operating synergies as real options that acquiring companies have in the post-acquisition M&A process. The paper builds on the synergistic restructuring theory, which states that both acquisitions and divestitures are wealth-creating activities. Acquisition synergies are broadly defined as arising both from resource redeployments between the acquirer and the acquisition target company and the executed divestitures of target’s assets within the post-acquisition process. We present a procedure to ex-ante calculate the first approximate value of the synergies in the screening stage of the M&A process. We argue that synergies are highly uncertain and require significant management actions and, for that reason, an appropriate method for the valuation is the fuzzy real options pay-off method, which is presented as an integrated part of a decision support system built for the screening of potential acquisition targets. The paper also discusses the ordering of acquisition candidates according to their total value based on the presented fuzzy measure.


Option to Acquire, LBOs and Debt Ratio in a Growing Industry

Makoto Goto, Hokkaido U., Japan

In this paper, we investigate LBO in a growing industry where the target company has a growth option. Especially, we focus the bidder's option to acquire the target company. An important setting is that the optimal timing is determined under the capital constraint. As our main results, we show that a growth option leads to delay in LBO, high leverage and low risk, and that default risk has the opposite sensitivity before/after growth.


Mergers and Market Valuation

Vera Baranouskaya, Swiss Finance Institute, Switzerland

The fact that periods of high market valuations often coincide with periods of intensive merger activity (especially stock merger activity) (so called `merger waves') has been extensively documented in merger literature. This paper investigates connection between market valuation and a type of merger (stock, cash) using real options setup. The study relates to the literature that uses real options approach to dynamically investigate merger decisions. Lambrecht (2004), Morellec and Zhdanov (2005) and Hackbarth and Morellec (2008) model mergers as dynamic option exercise games between target and bidder(s) in which both timing and terms of mergers are determined endogenously. While these authors consider mergers for stock only, this paper aims at analyzing both stock and cash mergers. Thus, for the two setups considered (the first one by Lambrecht (2004), and the second one by Morellec and Zhdanov (2005) and Hackbarth and Morellec (2008)) I extend the original model offering the opportunity of a cash merger to the players and then solve cash merger problem. The second setup depends on two correlated stochastic processes and requires numerical solution; to this end, I use the Least Squares Monte Carlo approach (LSM) by Longstaff and Schwartz (2001). In both setups, I solve for terms and timing of cash mergers. I compute option values to the players and introduce a measure of market valuation as weighed average of individual firm valuation in the second setup. I am able to demonstrate that in both setups, stock mergers should occur at high market valuation and at times of low market valuation cash mergers (or both types of mergers) should be observed. Thus, my conclusion agrees with existing empirical evidence on dominance of stock mergers at times of high market. I also investigate the dynamics of intra-industry mergers within the first setup. I solve for the optimal order of mergers inside an industry for different initial capital allocations to demonstrate that stock mergers in more concentrated industries occur at higher market valuation (i.e. later) as compared to mergers in less concentrated industries.


Environmental Policy & Sustainable Development (Track II)

Chair: John Kensinger, U. North Texas, USA


Carbon Price Uncertainty and Power Plant Greenfield Investment

Morgan Hervé-Mignucci, U. Paris-Dauphine, France

One of the stated objective of the EU ETS policy is to incentivize investment in low-carbon or carbon-free power generation technologies. Still, so far, the uncertainty about future carbon prices and the existence of technology-dedicated incentives like subsidies for CCS and feed-in tariffs or green certificates, might indicate that the carbon price has hardly played that role. The aim of this paper is twofold. First, the method developed should help utilities decision-makers integrate their views on carbon prices in an investment decision framework. Second, the method employed should ultimately help identify sensitivity points to guide policymakers when designing amendments to the rules governing the EU ETS. In order to understand how corporate decisions under carbon price uncertainty are taken, we model a utility’s investment decision in a multivariate real options framework. We consider a European utility that has a 10-year window to invest in a combination of various generation technologies (nuclear, IGCC, CCGT, pulverized coal and offshore wind). The model specifically account for uncertainty in carbon and power prices. The model is solved using the least-squares Monte Carlo approach (Longstaff and Schwartz, 2001 and Gamba, 2003) in order to account for various sources of uncertainty. Compared to the existing literature, we adapt the method to explicitly allow for capital rationing and choose among various technologies rather than just determining an optimal option exercise time. Policy-wise, early results of the model indicate that attempts to limit market price volatility and / or ensure a quick reversion to long-term equilibrium are of little help when compared to giving indications regarding significant cap level at various points in time (indicative of the deterministic trend). Furthermore, the price of carbon only contributes little to shifting investment decisions towards carbon-neutral or lower carbon investments. Rather, the price of carbon is critical to short-term adjustments (fuel-switching / trading / operation planning). Finally, technology-dedicated incentives seem to better incentivize the investment in carbon-neutral or lower carbon power plants.


Valuing Clean Development with Emission Credit Price Uncertainty

Hojeong Park, Korea U., Korea, Republic Of

Heesun Jang, Korea U., Korea, Republic Of

There are growing intrests in CDM (Clean Development Mechanism) project using afforestation or reforestation as an effective measure to control the greenhouse gases. Typical problems associated with A/R CDM projects are the stochastic price of emission credits (CER) and the renewal decision of A/R CDM after its expiry of the operation period. This paper presents an investment model to analyze the economic feasibility of A/R CDM project while considering CER price uncertainty and project renewal decision. Our analysis derives numerically explicit conditions under which A/R CDM projects provide sufficient returns in the presence of CER price uncertainty and investment irreversibility. For practical consideration of the model, A/R CDM project in Indonesia is studied. Keywords: real option, A/R CDM, uncertainty


Tender Offer for Wind Energy in Brazil: An Option-Games Explanation

Marta Corrêa Dalbem, PUC-Rio, Brazil

Leonardo Lima Gomes, PUC-Rio, Brazil

The first tender-offer for wind energy in Brazil was held in December 2009 and exposed wind entrepreneurs to unprecedented rules and a fierce price competition. Near 450 new projects initially applied to the 2009 first tender offer for wind energy, structured as a reverse auction with ceiling price at R$ 189/MWh; supply was over 3X demand and 71 projects won the bid, selling at prices in the R$ 131-153/MWh range. Among the winners, there are newcomers and companies that already operate wind farms in Brazil, including some which have wind equipment manufacturers as shareholders. Among the losers, some large companies such as Iberdrola, which has a significant experience in the wind industry. Apart from aggressive newcomers which were clearly outliers in the bid, the two groups - winners and losers - probably enjoy asymmetries not only in terms of investment costs, but also in terms of their beliefs on how the market for wind energy will evolve in Brazil. Is there a risk that less viable wind farms won the bid? This paper attempts to analyze this problem in the light of game-options theory and, more specifically, based on works such as Huisman (2001), and Pawlina&Kort (2002) for asymmetric duopolies. We conclude that discrepancy of beliefs regarding future wind energy prices in Brazil may have let lower capex/more profitable projects out of the bid. The risk of preemption of less profitable projects would have been lower if the government had made the perspectives for wind energy clearer. In addition, when firms are less informed of competitors’ actual views regarding the future, assuming that their own views prevail among players, the risk of preemption is lower, favoring a stronger wind industry in Brazil.


Downscale & Abandon Options (Track I)

Chair: Peter Kort, Tilburg U., Netherlands


The Option to Downscale Production in Recessionary Times

Kuno Huisman, Tilburg U., Netherlands

Peter Kort, Tilburg U., Netherlands

Jacco Thijssen, Trinity College Dublin, Ireland

In this paper we value the option of a firm to downscale production in recessionary times. It is assumed that this option is killed when the recession ends, which is modelled via a Poisson process. We show that the dis-investment trigger is nonmonotonic in the intensity of the Poisson process. In particular, if the probability of a short recession is large firms will dis-invest sooner. We also study the dis-investment problem in the case where the sunk costs cannot be financed with equity or debt, but only through cash. This creates a path-dependence in the option valuation which implies that there is no analytical solution for the dis-investment trigger. Instead we use a Longstaff-Schwartz-like regression-based Monte Carlo method to simulate the investment trigger. This shows that the dis-investment trigger decreases in the initial cash balance. This implies that cash-poor firms will downscale sooner than in the case with perfectly working equity markets.


Evaluation of Optional Cancellation Contracts

Leonardo Muller, IMPA, Brazil

Max Souza, U. Federal Fluminense, Brazil

Jorge Zubelli, IMPA, Brazil

We consider the problem of evaluating the cost of the optionality to cancel a future delivery of a commodity when the seller has a number of markets to choose from. The technique has potential applications to contracts of Liquefied Natural Gas loads and requires solving certain diffusion problems in a multi-variable context.


The After-tax Replacement Decision under Cost and Salvage Price Uncertainty

Roger Adkins, U. Salford, United Kingdom

Dean Paxson, U. Manchester, United Kingdom

We present an analytical solution for the after-tax replacement investment decision for an asset subject to deteriorating operating costs and salvage value. The advantages of solving the three-factor replacement model analytically are that it extends the scope to include salvage value and the depreciation tax shield, while yielding a solution more efficiently than purely numerical methods. We show that the incremental value rendered by the replacement has to exceed the net re-investment cost, a finding that mirrors the standard result for one-factor models. The replacement policy is shown to vary with asset age, with younger assets being replaced at a lower operating cost threshold than older assets, and to vary with the salvage value, which is inversely related to the threshold. In line with expectations, an operating cost volatility increase raises the threshold, but an increase in the salvage value volatility or a decrease in the correlation between the operating cost and salvage value lowers the threshold.


Theoretical Models & Issues (Track II)

Chair: Christer Carlsson, Åbo Academy U., Finland


Real Options under Ambiguity

Robert Kast, CNRS, Lameta, France

André Lapied, U. Aix-Marseille, France

David Roubaud, U. Aix-Marseille, France

A new class of real options models has recently emerged, characterized by the presence of ambiguity (or Knightian uncertainty). We discuss the rationale behind this proposal, identify a few constraints and underline some limits of such models. The key contribution of this paper is to rely on dynamically consistent Choquet-Brownian motions to represent ambiguity. This singularizes our approach from models proposed so far, based on the standard recursive multiple-priors preferences (or maxmin expected utility), where uncertainty is modeled through Geometric Brownian motions. By doing so, we wish to allow a broader spectrum of attitudes toward perceived ambiguity to be considered, through a newly defined index, that of ψ-ignorance. Our conclusions generalize some previous results from multiple-priors models, established in the case of extreme aversion to ambiguity only. We concur that risk and ambiguity may have different effects on real option valuations. But we also show that i) decision makers revealing different attitudes towards ambiguity will not value their projects identically and consequently will not exercise their options at the same time (if ever they should); more specifically, an ambiguity loving decision maker will keep its option opened for longer periods than if he was neutral towards ambiguity. The opposite holds true for an ambiguity averse decision maker. Furthermore, we show that ii) introducing perceived ambiguity suffices to modify the impact of a change in risk level itself on project valuation in the stopping region. An intricate relationship between risk and ambiguity appears strikingly in our model. Overall, decision makers’ preferences towards perceived ambiguity matter and should be taken into consideration when assessing decisions ex-post. This may help understand why in practice real options may be exercised later (or sooner) than predicted in the expected utility framework. Reducing the spectrum of preferences to extreme pessimism through a maxmin criterion would indeed limit the explanatory potential of these otherwise very appealing expanded real options models under ambiguity.


Optimal Timing in Vertical Supplier Relationships with Endogenous Cost

Etienne Billette de Villemeur, U. Toulouse, France

Richard Ruble, EMLYON Business School, France

Bruno Versaevel, EMLYON Business School, France

We study investment timing when firms rely on an outside supplier to provide a key specific input. The upstream firm's mark-up depends on the stochastic process followed by downstream flow profits. A vertical externality arises because the upstream firm's pricing induces the downstream firm to delay the exercise of its investment option. This disortion increases with both market growth and volatility. In contrast with the standard real option framework, greater volatility decreases firm value near the exercise threshold. If the input supplier has sufficient information regarding downstream demand, it can induce optimal investment timing by means of standard vertical restraints. Otherwise, the upstream firm benefits from the presence of a second downstream firm, which results in a downstream preemption race and acts as a substitute for vertical restraints. The input is then sold to the downstream leader at a discount which increases with volatility, and the leader invests at the optimal threshold, resulting in greater industry profits when the discounting term is large enough.


Valuing the Option to Store Natural Gas and Practice-based Heuristics

Guoming Lai, U. Texas at Austin, United States

Francois Margot, Carnegie Mellon U., United States

Nicola Secomandi, Carnegie Mellon U., United States

The valuation of the real option to store natural gas is a practically important problem that entails dynamic optimization of inventory trading decisions with capacity constraints in the face of uncertain natural gas price dynamics. Stochastic dynamic programming is a natural approach to this valuation problem, but it does not seem to be widely used in practice because it is at odds with the high-dimensional natural-gas price evolution models that are widespread among traders. According to the practice-based literature, practitioners typically value natural gas storage heuristically. The effectiveness of the heuristics discussed in this literature is currently unknown, because good upper bounds on the value of storage are not available. We develop a novel and tractable approximate dynamic programming method that coupled with Monte Carlo simulation computes lower and upper bounds on the value of storage, which we use to benchmark these heuristics on a set of realistic instances. We find that these heuristics are extremely fast to execute but significantly suboptimal as compared to our upper bound, which appears to be fairly tight and much tighter than a simpler perfect information upper bound; computing our lower bound takes more time than using these heuristics, but our lower bound substantially outperforms them in terms of valuation. Moreover, with periodic reoptimizations embedded in Monte Carlo simulation, the practice-based heuristics become nearly optimal, with one exception, at the expense of higher computational effort. Our lower bound with reoptimization is also nearly optimal, but exhibits a higher computational requirement than these heuristics. Besides natural gas storage, our results are potentially relevant for the valuation of the real option to store other commodities, such as metals, oil, and petroleum products.


Interactions, Capital Structure & Taxes (Track I)

Chair: Elettra Agliardi, U. Bologna, Italy


Tax Convexity, Investment, and Capital Structure

Kit Pong Wong, U. Hong Kong, Hong Kong

Yufeng Wu, U. Hong Kong, Hong Kong

This paper examines the interaction between investment and financing decisions of a firm using a real options approach. The firm is endowed with a perpetual option to invest in a project at any time by incurring an irreversible investment cost at that instant. The amount of the irreversible investment cost is directly related to the intensity of investment that is endogenously chosen by the firm. The firm is subject to a convex corporate income tax schedule in which profits are taxed at a higher rate while losses are taxed at a lower rate. At the investment instant, the firm can finance the project by issuing debt and equity such that the optimal capital structure is determined by the trade-off between interest tax-shield benefits and bankruptcy costs of debt. We show that the optimal investment intensity of the levered firm is identical to that of the unlevered firm. While the prevalence of tax convexity does not seem to affect the firm's investment decisions, it lowers the firm's optimal default trigger and leverage ratio in a quantitatively significant manner. Our findings thus suggest that any distortionary effect arising from tax convexity on the firm's investment decisions is almost completely neutralized by the adjustment in the firm's optimal capital structure.


Investment Timing and Intensity under Progressive Taxation

Kai Cheung Chu, U. Hong Kong, Hong Kong

Kit Pong Wong, U. Hong Kong, Hong Kong

This paper examines a firm's investment intensity and timing decisions using a real options approach. The firm is endowed with a perpetual option to invest in a project at any time by incurring an irreversible investment cost at that instant. The amount of the irreversible investment cost determines the intensity of investment with decreasing returns to scale. The project generates a stream of profit flows that is stochastic over time and increases with the intensity of investment. The firm's investment policy is characterized by an endogenously determined profit flow such that the investment option is exercised at the first instant when the firm's profit flow reaches this threshold level from below. Tax progression arises from an exogenously given tax exemption threshold that makes the average tax rate increase with the tax base. We show that corporate income taxes are not neutral when tax schedules are progressive.


Optimal Capital Structure with Sequential Options

Elettra Agliardi, U. Bologna, Italy

Nicos Koussis, Frederick U., Cyprus

A binomial lattice based framework for the analysis of finite investment options with finite operational phase is developed. Solutions for European and American type finite horizon investment options with optimal capital structure and a multi-stage investment setting with multiple debt issues are discussed. The analysis shows that optimal leverage ratios are not affected by option moneyness at the investment trigger confirming earlier literature results in perpetual horizon. Sensitivity results show that leverage ratios are lower when the operational phase is longer. Long term debt maturity is optimal when principal payments exist while the reverse is true in the absence of principal payments. Leverage ratios are higher for longer debt horizons for the case with principal payments while this result is reversed when no principal payments exist. Sensitivity results with respect to model parameters enhance our intuition about the impact of several parameters on the firm investment and default policy and firm value.


Computational Methods & Applications (Track II)

Chair: Luiz Brandão, PUC-Rio, Brazil


A Binomial Model for Mean Reverting Stochastic Processes: Application to Ethanol Industry Expansion

Carlos Bastian-Pinto, PUC-Rio, Brazil

Luiz E. Brandão, PUC-Rio, Brazil

Warren J. Hahn, Pepperdine U., United States

Binomial trees are widely used for both financial and real option pricing due to their ease of use, versatility and precision. However, the classic approach developed by Cox, Ross, and Rubinstein (1979) applies only to a Geometric Brownian Motion diffusion processes, limiting the modeling choices. Nelson and Ramaswamy (1990) provided a general method to construct recombining binomial lattices which was used by Hahn and Dyer (2008) to develop a censored recombinant Mean Reverting model. These models, although more computationally complex in programming than the Cox et. al. (1979) binomial model, are fundamentally simpler than alternative approaches such as trinomial trees or simulation methods for American options. In this paper we extend the mean reverting model of Hahn and Dyer (2008) and propose a non-censored model that is more precise and has some other distinct advantages. We compare these two approaches and present the results of applying these models to evaluate a hypothetical real option.


Valuing Real Options with Changing Volatility using Trinomial Trees

Tero Haahtela, Helsinki U. Technology, Finland

This paper presents a recombining trinomial tree for valuing real options with changing volatility. The trinomial tree presented in this paper is constructed by simultaneously choosing such a parameterization that sets a judicious state space while having sensible transition probabilities between the nodes. The volatility changes are modeled with the changing transition probabilities while the state space of the trinomial tree is regular and has a fixed number of time and underlying asset price levels. The presented trinomial lattice can be extended to follow a displaced diffusion process with changing volatility, allowing also taking into account the level of the underlying asset price. The lattice can also be easily parameterized based on a cash flow simulation, using ordinary least squares regression method for volatility estimation. Therefore, the presented recombining trinomial tree with changing volatility is more flexible and robust for practice use than common lattice models while maintaining their intuitive appeal.


Real Options in Electricity Capacity Generation

Joachim Gahungu, U. Louvain, Belgium

Yves Smeers, U. Louvain, Belgium

This paper studies capacity expansion for a competitive electricity industry when agents consider investment as an option exercise on a real asset. The originality of this work is that the electricity price process is endogenously given in an unconventional manner : it solves a multi-technology optimization problem. The direct consequence of this sophistication is that one can not separate the option to invest between technologies. One is forced to evaluate directly the entire expansion plan as a whole. A necessary mathematical tool to work in this direction is singular stochastic control / optimal stopping equivalence often used in real options. We’ll show as one proceeds that the drawback of price internalization is dramatic for interdependent technologies as it prevent for an optimal stopping - stochastic control to hold and, at the same time, makes our ability to prove optimality of myopia less likely. The addition of a myopia assumption as a remedy to reach an investment criterium is discussed. We motivate the fact that myopia, well known to have been proved optimal in symmetric cases, is likely to be the observed behavior under asymmetries. A numerical and practical solution grounded on myopia arguments is worked out by combination of analytic treatment and forward Monte Carlo simulations.


Panel Discussion: Current State, Challenges and Future Prospects

Moderator: Gordon Sick, U. Calgary, Canada


Elettra Agliardi, U. Bologna, Italy

Luiz Brandão, PUC-Rio, Brazil

Christer Carlsson, Åbo Academy U., Finland

Kuno Huisman, Tilburg U., Netherlands

John Kensinger, U. North Texas, USA

Raffaele Oriani, Luiss U., Italy

Sigbjørn Sødal, U. Agder, Norway

Closing Remarks

Lenos Trigeorgis, U. Cyprus



Home | About the Conference
Past Papers | Contacts