Options Theory Research Articles

Real option-based optimization for financial incentive allocation in infrastructure projects under public-private partnerships

Financial incentives that stimulate energy investments under public-private partnerships are considered scarce public resources, which require deliberate allocation to the most economically justified projects to maximize the social benefits. This study aims to solve the financial incentive allocation problem through a real option-based nonlinear integer programming approach. Real option theory is leveraged to determine the optimal timing and the corresponding option value of providing financial incentives. The ambiguity in the evolution of social benefits, the decision-maker’s attitude toward ambiguity, and the uncertainty in social benefits and incentive costs are all considered. Incentives are offered to the project portfolio that generates the maximum total option value. The project portfolio selection is formulated as a stochastic knapsack problem with random option values in the objective function and random incentive costs in the probabilistic budget constraint. The linear probabilistic budget constraint is subsequently transformed into a nonlinear deterministic one. Finally, the integer non-linear programming problem is solved, and the optimality gap is computed to assess the quality of the optimal solution. A case study is presented to illustrate how the limited financial incentives can be optimally allocated under uncertainty and ambiguity, which demonstrates the efficacy of the proposed method.

Invest or regret? An empirical investigation into funding dynamics during the final days of equity crowdfunding campaigns

In this study, we use the options theory of investment to investigate the funding behaviour of investors in equity crowdfunding. Options theory argues that when faced with uncertainty, investors have the ‘option’ to delay their irreversible investments, although incur a cost in doing so. Demonstrating that investments in equity crowdfunding are characterised by low levels of irreversibility (i.e., they are semi-reversible), moderate costs of delay and high levels of uncertainty, we follow the predictions of options theory in hypothesising that investors may rationally delay their investments in order to gain new information about the quality of businesses in which they invest. We find empirical evidence in support of these arguments when investigating the dynamics of investment activity in campaigns hosted on the UK equity crowdfunding platform Crowdcube.

The investment-uncertainty relationship in the oil and gas industry

Recent studies of the oil market demonstrate endogeneity of the oil price by modelling it as a function of consumption and precautionary demands and producers’ supply. However, studies analysing the effect of oil price uncertainty on investment do not disentangle uncertainties raised by underlying components which play a role in the oil market. Accordingly, this study uses a new approach to investigate the relationship between investment and uncertainty for a panel of U.S. firms operating in the oil and gas industry. We decompose oil price volatility to be driven by structural shocks that are recognized in the oil market literature, over and above other determinants, in order to study whether the investment uncertainty relationship depends on the drivers of uncertainty. Our findings suggest that oil market uncertainty lowers investment only when it is caused by global (consumption) oil demand shock. Stock market uncertainty is found to have a negative effect on investment with a year of delay. The results suggest no positive relationship between irreversible investment and uncertainty, but interestingly, a positive relation exists for reversible investment. This finding is in line with the option theory of investment and implies that the irreversibility effect of increased uncertainty dominates the traditional convexity effect.

Real options with endogenous convenience yield

AbstractTraditional real options theory highlights the impact of risk on the timing of investment decisions. However, in practice, corporate projects often involve a preliminary exploratory stage, incurring a running cost and convenience yield. By analogy with commodity futures theories, we model such multistage corporate projects in a feedback‐control framework, with a dynamic aggregate convenience yield/running cost that interacts with the decisions to enter or exit the preliminary stage. We provide a closed‐form solution for this compound options model. The solution provides insight and quantifies of the optimal strategy for prevalent corporate projects with a preliminary exploration stage.

A financial option perspective on energy security and strategic storage

On the whole, research into energy security falls into one of three perspectives: The political perspective, the engineering and geologic perspective, or the economic perspective emphasising market resilience. Common to these perspectives is the emphasis upon examining exposure to supply disruption, but not its probability of occurrence. As petroleum markets have shown themselves generally resilient to secular events and actual disruptions rare, despite perennial concerns, we ask if our understanding of security cannot be improved? We apply financial option theory to three eventful periods to learn the expectations of market participants on the probability of disruptions. We find the forward-looking views of petroleum market participants to be accurate with regard to both price persistence and the resilience of markets in absorbing shocks. Our results cast doubt upon the need for emergency inventories unless justified to dampen market volatility on public good grounds.

Bankruptcy costs, economic policy uncertainty, and FDI entry and exit

AbstractIn this paper, we examine how the effect of economic policy uncertainty on foreign direct investment (FDI) entry and exit varies with the cost of bankruptcy resolution. Using a sample of bilateral FDI entry and exit for 23 countries and areas from 2004 to 2012, we find that an increase in bankruptcy costs in a country exacerbates the dampening effect of economic policy uncertainty on both FDI entry and exit. Subsample analysis reveals that the bankruptcy resolution channel only exists in high political risk countries. We also find that the bankruptcy resolution channel does not exist for foreign portfolio investment, which is consistent with real option theory. Broadly put, our contribution is at the nexus of institutional theory and FDI, as we identify the bankruptcy resolution channel through which economic policy uncertainty affects FDI entry and exit.

The Optimal Investment Strategy of P2G Based on Real Option Theory

This paper initially proposes a real options model for the investment of the Power-to-gas (P2G) plant based on uncertain operating cost which mainly refers to the price of electricity. Through the analysis of the uncertainty parameters affecting the operation of the P2G project, the mathematical model expressing the relations between the parameters of P2G operation cost, electricity price, sunk cost, and other parameters are established. The Brownian motion is utilized to describe the operation cost, based on which, the option value and the project value models of P2G are derived in detail. According to these two models, the optimal investment timing of the P2G device and the corresponding optimal investment capacity can be determined. The above models are verified by numerical simulation. In addition, the influence of the change of parameters on the investment timing and investment capacity in the real options model is studied. The results show that the volatility of electricity price has a greater impact on the option value of P2G project than that of other parameters. When there is a high operating cost uncertainty, waiting is a better option, and the investment can be performed when the operating cost falls to the cost with reference to the optimal investment timing.

Oil price uncertainty and unemployment

In this study, we empirically search the effects of oil price uncertainty and oil price shocks on U.S. unemployment rate using a GARCH-in-mean VAR model for the period 1974:q2–2017:q4. Based on our findings, we show that oil price uncertainty significantly increases unemployment rate in the U.S. economy. Likewise, our impulse-response analysis affirms that a positive oil price shock increases unemployment while the response of unemployment to a negative oil price shock is negative. Moreover, we reveal that unemployment rate reacts to positive and negative shocks asymmetrically. More specifically, the response of unemployment to negative oil price shocks is negative and slighter in size. Besides, oil price uncertainty is found to magnify the rise in the U.S. unemployment rate. These findings are in keeping with the real options theory which reveals that the uncertainty about goods' prices leads firms to postpone or abandon their production and investment and they seem to be robust to the use of different real oil price measures.

Monetizing the Value of Measurements of Equilibrium Climate Sensitivity Using the Social Cost of Carbon

There has been much work on the value of learning about climate and the value of information regarding the climatic system. The present research moves beyond an abstract hypothesis about future learning and considers concrete Earth Observing Systems that could enhance knowledge of the climatic system and better inform decision makers. This study shows how real options theory in combination with the social cost of carbon may help to calculate the value of information regarding equilibrium climate sensitivity and estimate the relative advantages of two different Earth Observing Systems (EOSs) for learning about ECS. One system aims to improve measurements of decadal global temperature increase and another targets measurements of decadal change of global cloud radiative effect. The paper concludes that a new EOS that substantially reduces the uncertainty in cloud radiative effect would be expected to have more value than improving estimations of the global surface temperature alone.

Correction to: Real options theory in international business

The original version of this paper was inadvertently published without one of the co-authors’ affiliations. Lenos G. Trigeorgis has an additional affiliation as follows:

Real options theory in international business

The last quarter century has witnessed substantial growth in applications of real options theory (ROT) to international business (IB) research. In this review, we explicate the core ROT concepts in the IB context and discuss the contributions of ROT-based research to three core IB issues: timing and scale of market entry or exit, entry mode and governance form, and the role of multinational networks. Based on our review, we propose a holistic ROT view of the multinational enterprise that synthesizes the insights of existing studies. Finally, to move the field forward, we highlight key questions and challenges in current ROT-based work, provide a more precise definition of exogenous and endogenous uncertainty, suggest empirical designs to test unique ROT predictions, and explore areas where ROT can be combined with other theoretical perspectives to better understand IB phenomena.

El modelo binomial, ahorros fiscales y valor ajustado de la firma por escenarios de continuidad o disolución

El descuento de flujos de fondo, en su versión tradicional, no incorpora valores contingentes de ahorros fiscales y los escenarios de continuidad o liquidación a los que se enfrenta la firma. El presente trabajo desarrolla, desde la teoría de opciones reales, un modelo binomial de valoración que incorpora el tratamiento contingente de los ahorros fiscales y los escenarios de disolución o continuidad, condicionados por el grado de endeudamiento. Para esto, se utilizó el enfoque metodológico del estudio de casos, exponiendo relaciones funcionales y ventajas respecto del descuento de flujos de fondos. Los resultados indican que el valor de la firma se ajusta a una función del tipo exponencial. El valor actual obtenido resume ahorros fiscales contingentes y escenarios de liquidación o continuidad.

Investing in antibiotics to alleviate future catastrophic outcomes: What is the value of having an effective antibiotic to mitigate pandemic influenza?

Over 95% of post-mortem samples from the 1918 pandemic, which caused 50 to 100 million deaths, showed bacterial infection complications. The introduction of antibiotics in the 1940s has since reduced the risk of bacterial infections, but growing resistance to antibiotics could increase the toll from future influenza pandemics if secondary bacterial infections are as serious as in 1918, or even if they are less severe. We develop a valuation model of the option to withhold wide use of an antibiotic until significant outbreaks such as pandemic influenza or foodborne diseases are identified. Using real options theory, we derive conditions under which withholding wide use is beneficial, and calculate the option value for influenza pandemic scenarios that lead to secondary infections with a resistant Staphylococcus aureus strain. We find that the value of withholding an effective novel oral antibiotic can be positive and significant unless the pandemic is mild and causes few secondary infections with the resistant strain or if most patients can be treated intravenously. Although the option value is sensitive to parameter uncertainty, our results suggest that further analysis on a case-by-case basis could guide investment in novel agents as well as strategies on how to use them.

The Application of Real Option to Renewable Energy Investment: A Review

This paper aims to give comprehensive review on the state of current researches and provide some reference for future research. For this purpose, the paper firstly analyses the evolution of real option theory and method, following with the characteristics of renewable energy investment. Then, the usability of real option to renewable energy investment is discussed, and the diverse applications of real option on renewable energy investment and policy evaluation are conducted. The directions for future researches are also presented in the end.

Design Rules, Volume 2: How Technology Shapes Organizations: Chapter 13 Platform Systems vs. Step Processes - The Value of Options and the Power of Modularity

The purpose of this chapter is to contrast the value structure of platform systems (e.g. a computer or a marketplace) with step processes (e.g. an assembly line or a steel mill). In distinguishing between step processes and platform systems, the chapter lays out the core theoretical arguments of the book. A step process is a technology that changes the material world in a predictable way that humans find useful or valuable. In contrast, a platform system is a technology designed to support the creation of options. Historically, the increasing importance of platform systems is inextricably bound up with the spread of digital technology and the related use of modular technical architectures to manage complexity and accommodate technical change. I go on to explain why platform systems have modular technical architectures, and to trace the intellectual history of modularity in early digital computers and software. I then use option theory to identify a set of complementary conditions—risk, modularity, and openness—that are favorable to the adoption of platform systems, I contrast these to the conditions—growing markets, automated machinery, and systematic management— favorable to the creation of large-scale flow production processes. This analysis in turn leads to a predicted correspondence between technologies and organizations. In essence, interdependent step processes require and reward modern corporations characterized by risk aversion, unified governance, hierarchical structure, coordinated by managers exercising direct authority. In contrast, platform systems require and reward platform ecosystems characterized by risk-taking, distributed governance, autonomy, coordinated by centralized rules and shared resources. Finally, I show how the benefits of flexible platform systems may be balanced against the benefits of efficient step processes in designing the architecture of large technical systems.

The Attraction of FDI to Conflicted States: The Counter-Intuitive Case of US Oil and Gas

States burdened with conflict have been considered to be undesirable destinations for foreign direct investment (FDI) due to, inter alia, political instability, regulatory unpredictability, and expropriation risk. However, we develop an alternative view based on corporate governance and real option theories. We analyze a dataset of FDI location decisions made in the Oil and Gas sector by 250 US firms across 44 countries between 2007 and 2013. After controlling for energy reserves, the results show counter-intuitively, that civil war and terrorism risks, and terrorist events are positively associated with US investment in Oil and Gas. US subsidiaries also show high levels of ownership commitment. It is tempting to conclude that US Oil and Gas is a wholly unique, resource-bound case, but we argue that this disconnect may have occurred for two reasons. First, a threat of conflict and violence can make MNEs exercise their growth options and expand resource extraction sooner rather than later. Second, political instability does not necessarily lead to higher levels of FDI expropriation risk. On the contrary, instability can reduce the incentives for the state to seize assets from technologically superior MNEs, i.e. it may reduce expropriation risk. Just as the rule of law and ‘good’ governance can constrain a state from expropriation, there are theoretical reasons why ‘bad’ governance resulting from instability and incapacity may do so, too.

Real Options Approach to Valuation

Although the academic literature on real options has grown enormously over the past three decades, the adoption of formal real option valuation models by practitioners appears to be lagging. Yet, survey evidence indicates that managers’ decisions are near optimal and consistent with real option theory. We critically review real options research and point out its strengths and weaknesses. We discuss recent contributions published in this issue of the journal and highlight avenues for future research. We conclude that, in some ways, academic research in real options has catching up to do with current practice.

Start-ups valuation predicted by fuzzy real options theory

Start-ups valuation predicted by fuzzy real options theory

Geopolitical Risk and Investment

Using a news-based index of geopolitical risk (GPR), we document a strong negative relationship between firm-level corporate investment and GPR. When the GPR index doubles, investment rate in the next quarter declines by 14% of its sample mean. The effect is more pronounced for firms with more irreversible investment or higher market power, confirming the real options theory. However, the effect is less significant for firms with a stronger ability to substitute labor for capital or with a higher labor-to-capital ratio, supporting the convex return theory. Furthermore, the impact of GPR on investment varies across geopolitically-sensitive sectors. It is stronger for firms in the tourism and its related sectors and is weaker for firms in the defense sector. Overall, our results suggest that the real options channel dominates the Oi-Hartman-Abel effect in driving the negative GPR-investment relationship.

Reálopciók az üzleti inkubációs folyamatban

THE AIMS OF THE STUDY Real option theory has been analyzed for more than forty years in more industries and research areas but some of these have received less attention. One potential but yet untapped area of real option theory application is the business incubation process, which can be a key success factor of start-up companies. The study focuses on the business incubation process and the real option theory and aims to present the steps of the business incubation process and the decision-making phases for both the business incubator and the participants, and to develop a framework that ensures the efficient operation of incubators. METHODOLOGY By exploiting and modelling uncertainty and managerial flexibility I examine the opportunities in business incubation process applying real option theory. In the course of the qualitative analysis I identify the different types of real options inherent in the business incubation process and determine the benefits of applying them as well as emphasizing their positive features. MOST IMPORTANT RESULTS Although many literature review sources treat incubation process models with a black box approach, considering the model process and its structure-oriented nature enables its in-depth analysis and conclusion about the potential in the incubation process. In the process we can also identify timing, staging, contract and growth real options and exercising or discarding these options ensures corporate value creation. RECOMMENDATION Identifying and exploiting real options gives scope for business incubators to achieve operational effectiveness and value-creation. They study and the subsequent research provide new approach to practitioners, including the real option logic and use real option valuation.