Technical uncertainty in real options with learning

Abstract

We introduce a new approach for incorporating uncertainty in the decision to invest in a commodity reserve. An investment is an irreversible one-off capital expenditure, after which the investor receives a stream of cashflow from extracting the commodity and selling it on the spot market. The investor is exposed to price uncertainty as well as uncertainty in the amount of available resources in reserve (also known as “technical uncertainty”). They do, however, learn about the reserve levels over time and this is a key determinant in the decision to invest. To model the uncertainty surrounding the reserve levels and how the investor learns via estimates of the commodity in the reserve, we adopt a continuous-time Markov chain model; this allows us to value the option to invest in the reserve and to investigate the value of learning prior to investment.