Exercise Of Real Options Research Articles

Real Options and MNE Flexibility: The Strategic Response of US and EU MNEs to the US-China Trade War

Increasing volatility in global trade policies seemingly forces MNEs to seek operational flexibility. However, real options theory which focuses on operational flexibility has rarely considered trade policy as the focal source of uncertainty for international operations. Despite recent scholarly efforts to investigate the economic impact of trade wars, how firms respond to such conflict has been underexplored. Motivated by these gaps in the literature, I engage in a firm-level, real-options analysis of the strategic responses of MNEs invested in a host country involved in a trade war. Specifically, I maintain that MNE subsidiary operations in a trade-war-involved host country exercise real options to counter threats and opportunities that depend on the status of the MNE’s home country. Using the US-China trade war as the empirical context, I use panel data composed of 1,424 US-MNE and 975 EU-MNE Chinese subsidiaries from 2016 to 2019 and conduct a difference-in-differences analysis. The empirical results corroborate the theoretical priors: US and EU MNEs exercise the hybrid options as an adaptive response to the trade war. Also, I find that the multinationality of US and EU MNEs facilitates their exercise of switching options in response to the trade war.

The Valuation of Illiquid Assets: A Focus on Private Equity and Real Estate

This article reviews methods that can be used to value illiquid investments, focusing on private equity and real estate. The authors discuss the traditional valuation methods, particularly the net present value (NPV) rule, and show in what circumstances these can lead to suboptimal investment decisions. Emphasis is placed on a real option valuation framework that can alleviate some of the drawbacks of traditional approaches. A new jump-diffusion option pricing model and a numerical example are presented to show the usefulness of such a framework in valuing illiquid assets, in particular venture capital funds. They maintain that, under harmonized parameter estimation techniques, the NPV rule can be viewed as the lower bound in a competitive market and the real option exercise criteria and valuation models as providing the upper bound to value and time investments in illiquid assets. The knowledge of such bounds should enhance the decision-making process concerning allocating funds to alternative investments.

Real options, risk aversion and markets: A corporate finance perspective

We analyze how the presence of financial markets affects the optimal exercise of real options for a risk averse agent. Extending the results of Shackleton and Sodal (2005), we characterize the optimal exercise rule in terms of a benchmark portfolio, even for the case of an incomplete market, facilitating the minimal martingale measure. We unambiguously characterize the effect of idiosyncratic risk on the speed of exercise of the option. We further show that systematic risk can accelerate execution and reduce the value of a call-type option, in contrast with the standard view that both value and execution threshold are increasing in volatility.

Model-free analysis of real option exercise probability and timing

This paper investigates the effects of modifying a real option's characteristics on its holding value and optimal exercise decision using quantile-preserving spreads and stochastic dominance. We show that the change in exercise probability and timing depends on the preserved quantile, strike price, time of modification, and modification symmetry, and we significantly generalize previously obtained results to an unspecified underlying process and a general call-like payoff function. Our results offer testable predictions that contribute to the literature on climate finance, real options, and financial options and provide practical guidance for determining how to modify a real option to increase or decrease its exercise probability and timing.

Intrinsic Real Option Value: Empirical Evidence from Commercial Real Estate Investors

We investigate how local information externalities affect investments in tangible durable assets via real options. Using geocoded transaction-level data on US commercial properties from 2000 to 2018, we find that investors have a higher propensity to invest in a property for immediate redevelopment when its capital intensity and type of commercial activity differ from those of recently built nearby properties. Information externalities affect 'buy-to-redevelop' investment strategies as much as the asset capital depreciation - a main determinant of real option exercise highlighted in the literature - and can increase up to 30 percent the investors' willingness to pay to invest in the property.

Correction to: Real Option Exercise Decisions in Information Technology Investments: a Comment

The original version of this article unfortunately contained a mistake in the reference section, specifically references 7 and 9. Reference 7 should be changed from “Nau, Robert F, McCardle, Kevin F (1992) Arbitrage, rationality, and equilibrium, Decision making under risk and uncertainty (Durham, NC, 1990), Theory Decis. Lib. Ser. B Math. Statist. Methods, 22 pp 189–199, Kluwer Acad. Publ., Dordrecht” to “Nau RF, McCardle KF (1991) Arbitrage, rationality, and equilibrium. Theory Decis 31(2-3):199–240”. Reference 9 should be changed from “Dybvig PH, Ross SA (1987) Arbitrage. In: Eatwell J, Milgate M, Newman P (eds) The New Palgrave: a dictionary of economics, vol 1, A to D Macmillan Press, London, pp 100–106” to “Dybvig PH, Ross SA (1987) Arbitrage. In: Eatwell J, Milgate M, Newman P (eds) The New Palgrave: a dictionary of economics, vol 1, A to D. Macmillan Press, London, pp 100–106”.

Real Option Exercise Decisions in Information Technology Investments: a Comment

The paper comments on Khan et al. (J Assoc Inf Syst 18(5):372–402, 2017), who study real option exercise decisions in the context of a single IT project and in a portfolio setting, respectively. The issues identified concern the concept of (economic) rationality and the treatment of project interdependencies. The explanations provided may prove useful in other contexts.

Does CEO myopia impede growth opportunities?

We present evidence that the negative impact of CEO short-termism on firm value can be attributed to a sub-optimal exercise of real options. Accordingly, the value relevance of firms’ real options portfolios is maximized in the absence of CEO temporal myopia. Moreover, the impact of real options on firms’ stock returns’ idiosyncratic characteristics is more pronounced when CEOs’ decision horizons are longer, in line with the view that enhanced operating flexibility from longer decision horizons can amplify the convexity of real options’ payoffs. These findings have important implications regarding the impact of CEO career horizons on corporate strategies and board decisions related to CEO incentives and succession.

Real Options, Risk Aversion and Markets

We analyze how the presence of financial markets effects the optimal exercise of real options for a risk averse agent. In this process we examine the role of the minimal martingale measure and the Capital Asset Pricing Model (CAPM). Using value-matching and smooth-pasting conditions, we generalize results of Shackleton and Sodal (2005) for the one-dimensional complete market case and extend their framework to a multi-dimensional incomplete market setup, identifying the minimal martingale measure as the appropriate reference measure, consistent with the CAPM. We provide a characterization of the optimal exercise rule in terms of the capital market line. Our approach allows us to unambiguously characterize the effect of systematic risk on the speed of exercise of the option, but we also show that the effect of idiosyncratic risk can contravene conventional belief. Finally we demonstrate in form of numerical examples that it is indeed crucial to correctly account for the presence of financial markets and its interplay with risk aversion when exercising real options, as otherwise large financial losses can occur.

Real options and asymmetric volatility in light of the firm’s growth opportunities

ABSTRACT This study proposes a real options exercise mechanism as a novel explanation for the asymmetric volatility phenomenon. We suggest that asymmetric volatility stems from the exercise of real call options following positive shocks and the exercise of real put options after negative shocks. Furthermore, we uniquely link asymmetric volatility to real options and firm’s growth opportunities. Using US market return data from the period spanning 1926–2018, this paper demonstrates that following a positive market shock generating return volatility, growth-firms exercise more real call options than value-firms. This further alleviates growth-firms’ volatility response, thereby resulting in higher asymmetric volatility. Book-to-market portfolio analyses provide significant empirical evidence that the firm’s growth opportunities intensify the asymmetric volatility phenomenon.

Real Option Exercise: Empirical Evidence

Abstract We study when and why firms exercise real options. Using detailed project-level investment data, we find that the likelihood that a firm exercises a real option is strongly related to peer exercise behavior. Peer exercise decisions are as important in explaining exercise behavior as variables commonly associated with standard real option theories, such as volatility. We identify peer effects using localized exogenous variation in peer project exercise decisions and find evidence consistent with information externalities being important for exercise behavior. (JEL G30, G31, G32)

Real Option Exercise Decisions in Information Technology Investments: A Comment and Suggestions for Further Research

Real Option Exercise Decisions in Information Technology Investments: A Comment and Suggestions for Further Research

Real Option Exercise: Empirical Evidence

We study when and why firms exercise real options. Using detailed project-level investment data, we find that the likelihood that a firm exercises a real option is strongly related to peer exercise behavior. Peer exercise decisions are as important in explaining exercise behavior as variables commonly associated with standard real option theories, such as volatility. We identify peer effects using localized exogenous variation in peer project exercise decisions and find evidence consistent with information externalities being important for exercise behavior.

IRREVERSIBLE INVESTMENTS AND AMBIGUITY AVERSION

Real option valuation has traditionally been concerned with investment under project value uncertainty while assuming that the agent has perfect confidence in a specific model. However, agents do not generally have perfect confidence in their model and this ambiguity may affect their decisions. In addition, the value of real investments is not typically fully spanned by tradable assets because markets are incomplete as is typically the case in energy and commodities. In this paper, we account for the agent’s aversion to model ambiguity and address market incompleteness through the notion of robust indifference prices. We derive analytical results for the perpetual option to invest and the linear complementarity problem that the finite-time version of this problem satisfies. Ambiguity aversion has a number of effects on decision making some of which cannot be explained by altering the agent’s risk aversion. For example, ambiguity averse agents are found to exercise real options both earlier and later than their ambiguity neutral counterparts, depending on whether ambiguity stems from uncertainty in the dynamics of the project value or the dynamics of a hedging asset.

The Impact of Power Distance and Uncertainty Avoidance on Real Options Exercise: Potential for Suboptimal Time Delays and Value Destruction

ABSTRACTReal options (RO) valuation has been promoted as a way to evaluate investment opportunities and make investment decisions that takes into account the value of managerial flexibility in the face of uncertainty. Although RO enjoys a substantial body of literature considering its application and suitability in different situations, the impact of national culture on the application of RO has received little attention. Values embedded in national culture affect the behavior of managers. In particular, these values play a role in how managers frame information, communicate, and make decisions, directly and indirectly affecting behavior through cultural layers such as organizational culture. National culture, therefore, can systematically affect the application of RO, potentially leading to suboptimal outcomes. In this article, we hypothesize how 2 particularly relevant dimensions of culture, power distance and uncertainty avoidance, affect RO exercise, and estimate the magnitude suboptimality of these effects using a model we develop for the case of a put option. Our estimates suggest RO may not always be a superior valuation approach to net present value for national cultures with certain characteristics.

Examining Real Options Exercise Decisions in Information Technology Investments

Researchers have advocated real options thinking (ROT) for evaluating and managing risky IT investments to account for managerial decision flexibility. Effective ROT is a three-step process that requires managers to recognize, value, and exercise options embedded in IT projects. Prior research has illustrated the existence of managerial bias in the recognizing and valuing real options. However, little research has examined real options exercise decisions. Hence, we use prospect theory to examine whether IT managers demonstrate systematic biases while exercising real options in IT projects and portfolios. We also study whether one can control or mitigate such biases. We found evidence of biased (suboptimal) real option exercise decisions in IT projects and in IT portfolios. However, we found differences in biased decision making between a single project and a portfolio scenario. We also found that project scale and real option type influenced vulnerability of a project to biased decision making. In addition, simplifying the presentation of the net effects of real options exercise decisions can help reduce bias, especially for large project portfolios. We discuss the implications of these results on theory and practice.

Confronting the financing impasse: Risk management through internationally staged investments in tidal energy development

Progress toward commercial deployment of in-stream tidal energy devices and commercial arrays has frequently met with delays, particularly in the UK and Canada. While some delays are due to the manifestation of the uncertainties inherent in new technology development, this study seeks to better understand the strategic timing decisions of tidal energy conversion companies in developing a globally-distributed renewable resource. The study consists of semi-structured interviews with executives and senior managers of organizations in the international tidal energy industry. Themes emerging from the interviews find companies manage risk by timing their investments across an international portfolio of seabed leases, consistent with the exercise of real options.

"Patent Litigation as Real Option Exercise in a Highly Competitive, Dynamic Market"

What explains the alarming uptick in the number of patent infringement suits filed by corporate actors? While there may be numerous determinants of patent litigation activity, we propose one possible explanation using two theoretical lenses: real options and competitive dynamics. According to these theoretical frameworks, incumbent firms acquire patents as real options for their potential strategic value under uncertainty, which is the market competitive dynamics. The timing of the option strike depends on the resolution of uncertainty, defined as a competitor's increase in market share. As a reaction to this competitive action, incumbent firms may choose to exercise their options by filing patent infringement suits against their competitors. This phenomenon is observed especially in industry settings with strong appropriability and weak complementary asset value, where firms are more prone to engage in a competitive, rather than cooperative behavior. We empirically test the hypotheses with data from the smartphone industry using panel and rare events logistic regression analysis.

Knightian Uncertainty and Capital Structure

My dissertation aims to understand a firm's optimal capital structure decision when it confronts Knightian uncertainty. It contains three chapters. In Chapter One, I derive the optimal capital structure of a firm when its manager is ambiguity-averse. My model predicts substantially lower leverage for such firms, in comparison to traditional static trade-off models. I use the 1982 Voluntary Restraint Agreement (VRA) on steel import quotas between the U.S. government and the European Community as an exogenous reduction in Knightian uncertainty faced by firms in the U.S. steel industry. Using a difference-in-difference methodology, I find that when uncertainty is resolved, a median firm in the U.S. steel industry increases its market and book leverage by approximately 12 percent relative to a matched control firm from another industry. The results are not explained away by changes in traditional risk factors or by a change in expected future profitability. In Chapter Two, I develop a new measure of Knightian uncertainty using a mixture of normal distributions. Using this novel measure, I find that a median firm in the sample decreases its market leverage by approximately 3.6 percent, when the firm's measure of uncertainty increases by one standard deviation. I also find an increase in a firm's uncertainty measure from the minimum to the maximum is associated with a 6.3 percent increase in the firm's propensity to take almost zero leverage. In Chapter Three, I consider a firm's decision to exercise real options, when the firm faces Knightian uncertainty about the evolution of project value. I provide two continuous time applications extended from the discrete time applications in Miao and Wang (2011) that show the value of waiting (which increases with risk) decreases with uncertainty. I incorporate ambiguity-averse investors who are uncertain about the evolution of a firm's assets into the dynamic capital structure model of Leland (1994). I show that even in this dynamic setting, uncertainty provides a more plausible explanation for firms taking on low leverage than risk alone.

A Longstaff and Schwartz Approach to the Early Election Problem

In many democratic parliamentary systems, election timing is an important decision availed to governments according to sovereign political systems. Prudent governments can take advantage of this constitutional option in order to maximize their expected remaining life in power. The problem of establishing the optimal time to call an election based on observed poll data has been well studied with several solution methods and various degrees of modeling complexity. The derivation of the optimal exercise boundary holds strong similarities with the American option valuation problem from mathematical finance. A seminal technique refined by Longstaff and Schwartz in 2001 provided a method to estimate the exercise boundary of the American options using a Monte Carlo method and a least squares objective. In this paper, we modify the basic technique to establish the optimal exercise boundary for calling a political election. Several innovative adaptations are required to make the method work with the additional complexity in the electoral problem. The transfer of Monte Carlo methods from finance to determine the optimal exercise of real-options appears to be a new approach.