To expand and to abandon: Real options under asset variance risk premium

Abstract

This paper focuses on the variance risk premium of project returns and its impacts on the real options to expand and to abandon a project. Variance risk premium measures the hedging costs associated with the time-varying variance of the returns. We find that the variance risk premium increases the real option value to expand and to abandon a project. Hence, the variance premium delays both abandoning and expanding the project. Our setting also enables us to study the multi-stage decisions with real options under the variance risk premium. For example, we consider an abandonment or a re-expansion add-on attached to an expansion project, which is a reminiscence of how our framework facilitates modeling compound real option structures in the presence of the variance risk premium. We present two applications of our models that involve Ford Motor company and battery storage investments for electricity distribution networks. These cases demonstrate how the proposed framework in this paper can be applied to real world decisions, and, moreover, they establish a baseline for how much decisions can be improved when variance risk premium is included in the modeling.