Option Value Approach Research Articles

An opportunity cost model to value deferral options

This study discusses a real options valuation approach based on the familiar opportunity cost concept. After demonstrating the equivalence of the opportunity model to the binomial lattice approach of Cox, Ross, and Rubinstein (CRR), we discuss its attributes through simple numerical examples. In contrast to the CRR approach, the transparency of the opportunity model provides an intuitive and economical baseline for managerial discussions and decision-making. We focus on the opportunity costs inherently embedded in the real options value (ROV); therefore, our study is distinct from most other studies, which consider them as the exogenous input to the ROV.

An option-value framework for valuing mining streams

This paper introduces an option-value framework for valuing mining streams. A stream has the same economic characteristics as a portfolio of European call options. Since a stream can be replicated with a portfolio of European call options, the option-value approach to valuing streams is correct. At the same time, there are reasons to use a simpler alternative to the Black-Scholes Model. This paper provides a simple option-value equation for valuing streams.

Identifying the fair value of Sharpe ratio by an option valuation approach

This study aims to identify a theoretical fair value of the Sharpe ratio. For this purpose, we propose a formula with a closed-form solution to estimate a fair, expected, or ex ante value for the Sharpe ratio by framing it in the option pricing model. We find that firm value, growth rate, return volatility, risk-free rate, and the maturity and face value of the debt contract are determinants of the Sharpe ratio. In particular, a firm’s investing and financing policies can affect the firm stock’s Sharpe ratios. Contrary to what might reasonably be expected, our results show that a firm with a higher equity value tends to have a lower Sharpe ratio value. The results show the potential and feasibility of integrating three fields in future research: performance evaluations, option pricing, and corporate finance.

Value Maximizing Decisions in the Real Estate Market: Real Options Valuation Approach

The real estate market of EU countries has undergone a severe global financial crisis 2008–2009, recovered successfully later, and now experiencing significant uncertainty due to the COVID-19 pandemic event. Significant volatility of the real estate business is once again evident, just as it was following the global financial crisis. The paper aims to provide a case study of a real estate project by giving insight into the Latvian real estate project that had been experiencing similar economic uncertainty, to demonstrate hybrid real options valuation (ROV) method to adapt real estate investments to changing circumstances and to develop the decision-making solution to similar EU real estate problems during the pandemic. The paper provides the “step-by-step” ROV application’s methodology in real estate development projects. The presented methodology is a powerful managerial risk management tool for the executives of similar real estate development projects in the EU countries struggling to make investment decisions in the pandemic and post-pandemic period. Since any estimation includes assumptions, ROV results should be interpreted and perceived as approximations only. The future works can provide robust ROV analyses and interpretations regarding the demand for real estate, showing quantitatively how competition can impact strategic investment decisions.

A general method for valuing complex capital structures

We develop a numerical method based on the Cox et al. (1979) binomial tree option valuation approach that can accommodate arbitrarily complex capital structures with varying debt maturities and seniorities, as well as preferred stock and warrants. The method provides straightforward valuation for common bond market features such as convertibility and prepayment options, as well as sinking fund provisions, that have proven challenging to model analytically.

A General Method for Valuing Complex Capital Structures

We develop a numerical method based on the Cox et al. (1979) binomial tree option valuation approach that can accommodate arbitrarily complex capital structures with varying debt maturities and seniorities, as well as preferred stock and warrants. The method provides straightforward valuation for common bond market features such as convertibility and prepayment options, as well as sinking fund provisions, that have proven challenging to model analytically.

Technical Review Panel for the PIMS Model: Final Report

In April of 2013, the Pension Research Council of the Wharton School at the University of Pennsylvania convened a Technical Review Panel, comprising ten experts whose task it was to review the Pension Benefit Guaranty Corporation’s (PBGC) Pension Insurance Modeling System (PIMS), including inputs, outputs, and model assumptions. The review was intended to provide a formal evaluation of the technical adequacy of the model by outside experts. Each expert participating on the Technical Panel was asked to review background material (see References) and focus on a particular aspect of the PIMS model. The list of panelists and topics was developed by the Council in discussion with the Social Security Administration (SSA). This report and the appended papers herein from our Technical Panel comprise the Final Report under this project.The Panel’s key findings may be summarized as follows:1. The PIMS models are an important and valuable tool in modeling the Agency’s liability risk. To the best of our knowledge, there is no other model that can do a comparable job.2. Nevertheless, some improvements could be integrated in the Agency’s approach to modeling. Those deserving highest priority attention in the experts’ view are the following:a) Incorporating systematic mortality risk (i.e., treat mortality and longevity as stochastic variables);b) Including new asset classes increasingly found in defined benefit plan portfolios (e.g. commercial real estate, private equity funds, infrastructure, hedge funds, and others);c) Developing a more complex model for the term structure of interest rates; andd) Incorporating an option value approach to pricing the insurance provided.3. The Agency could also do more to communicate the range of uncertainty and potential for problems associated with the PBGC’s financial status. This could include additional information including the Conditional Value at Risk (CVaR), and perhaps an ‘intermediate,’ ‘optimistic’, and ‘pessimistic’ set of projected outcomes, as well as the expected ‘date of exhaustion’ for assets backing pension benefits insured by the PBGC.

Why are regional jets less used in emerging economies? A real options valuation approach and policy implications

In this paper we offer an explanation for why regional jets are less used in emerging economies by using a real options valuation (ROV) approach. Our ROV analysis is based on the observation that airlines are operating under different development and regulatory environments between emerging economies and developed economies. We quantify the values of the options using a case study of aircraft acquisition by airlines in the US, Brazil and China. It is found that although a theoretical value gap (a negative ROV) exists between narrow-body aircraft and regional jets (e.g., between A320 and E190) for the US carrier that operates in the condition of a low initial passenger volume per trip and a low passenger growth rate, the gap weakens and a positive ROV is possible for the Brazilian and Chinese carriers facing a high growth rate. Furthermore, regulatory restrictions faced by Chinese carriers have a positive influence on the ROV that is biased towards narrow-body aircraft over regional jets, although this influence is less than the positive ROV impact from the high growth rate. The managerial and policy implications are also discussed.

A Real Options Analysis of Spacecraft Software Product Line Architectures

Software and systems engineering for aerospace platforms presents many unique challenges. The decision if, and how, to employ software product line architectures is one recurring question. Real options analysis—applying option valuation techniques to budgeting decisions—can be a powerful tool for engineering managers, project leaders, and mission directors. In this paper, we demonstrate a real options valuation approach to explore this question.

Sustainable Value of Investment in Real Estate: Real Options Approach

The issue of application of real option valuation approach in the valuation of investment project is presented in the article in a way in which the flexibility of the project could be included in the process of its valuation. The authors apply the valuation approach in case of a specific investment project in the real estate in the capital city of the Czech Republic—Prague, using the option to expand, to contract, and to abandon the project. The main aim of this case study is to present a practical application of the investment valuation and to construct an option pricing model for real estate investment which considers and integrates as many aspects of the investment and market environment as possible to describe the best situation of the real estate market and its development. The valuation of the investment is carried out using a universally applicable numerical method of binomial trees. The results obtained are subjected to the sensitivity analysis with respect to the discount rate, value of the most influential parameter of the volatility and the input option parameters. The results of the valuation of the project obtained using the real option approach are important mainly for the management of the company in the process of quantification of the present value of future investments. Implementation of managerial interventions enables for optimizing the value of the project not only in case of favourable development of the real estate market, but particularly in case of unfavourable development. Therefore, they are important in order to protect an investor from potential high losses. Finally, the valuation of these interventions increases the present value of the project, contributing to the decision of the corporate management regarding its implementation.

The Valuation of Geothermal Power Projects in Indonesia Using Real Options Valuation

Geothermal power project should be carefully evaluated, because not only the project is large-scale and high-risk, but also huge investments are needed to make the project profitable. The purpose of this study is to evaluate and analyze the present value of the geothermal power plant projects in Indonesia using net present value and real options valuation approach to obtain better project value that indicates profitable investments. Project value determined based on Net Present Value (NPV). The Monte Carlo Simulation calculated NPV based on discount rate, production volume, and operation and maintenance (O&M) cost. The risk of the project defined with 3 scenarios to obtain NPV and calculate Expected Net Present Value (ENPV). The result of this study showed Real Options Valuation obtained the highest project value indicating a higher return of the project that was previously undervalued using NPV and ENPV. Real Options Valuation approach improved the project value by incorporating scenario analysis and strategic option in the valuation process.

Price development and bidding strategies for battery energy storage systems on the primary control reserve market

Decreasing prices on the German primary control reserve (PCR) market lead to an uncertain economic situation for battery energy storage systems (BESS) providing PCR. In a simulation-based approach, which takes into consideration application-specific aging, an economic assessment of a 1.5 MWh BESS providing PCR is conducted. Different bidding strategies for PCR auctions have been developed and their impact on revenues and battery aging has been investigated. Furthermore, following an option value approach, we analyzed how different PCR price paths and the time of investment affect the economic feasibility of BESS providing PCR.The results show that the choice of strategies developed in this paper do not have a substantial influence on revenues and battery aging. However, the development of PCR market prices and battery system costs is crucial for the economic feasibility of BESS providing PCR. Investments come with a high risk due to the volatility of PCR market prices and the uncertainty of future battery system prices.

Oil price volatility: A real option valuation approach in an African oil field

Low oil prices have been a major reason for the reduced investments in oil and gas projects around the world. This study analyzes how oil price uncertainties impact decision making concerning an African oil exploration and production project conducted under the Risk Service Contract (RSC) by incorporating managerial flexibility through the application of real options analysis (ROA). The study uses geometric Brownian motion (GBM) to model prices and the Petrel® and Eclipse® software to calculate the production profile. Managerial flexibility is incorporated through a binomial model. Initially, only a timing option is considered; in a second scenario, a timing option interacts with a scale option. The results advise against developing the oil field when uncertainties are disregarded. The results produced by adding uncertainty due to oil price volatility from a risk perspective and using a Monte Carlo simulation (MCS) indicate that the oil field has little chance of success. However, the results of considering managerial flexibility using the binomial model show that the uncertainty generates value for the project. Overall, having the option of investing on a larger scale appears to maximize the value of the asset.

Increased Asset Volatility Does Not Always Increase Shareholder Value

It is a common argument in the financial literature that increased volatility of firm’s assets returns causes an increase in the value of shareholders’ equity, at the expense of a lower value to debt-holders’ claims. This affirmation stems from the application to firm valuation of option pricing theory. According to the latter, firm’s equity can be seen as a call option with firm’s assets as the underlying of the option, and final promised debt value as the strike price of the option. The maturity of the option in this application is equal to the maturity of debt. For call options it is true that greater volatility, keeping everything else constant, will result in a larger value of the call option. But as I will explain in this working paper, this affirmation is not always true for the equity of the firm when corporate taxes are considered.In this working paper I show through a numerical valuation technique, similar to binomial pricing, that in a world with corporate taxes, increased asset volatility results, under certain conditions, in a lower value to shareholders. This comes at a benefit to the value of taxes paid to the government. I call this numerical option valuation approach, “numerical integration”.

Why Are Regional Jets Less Used in Emerging Economies? A Real Options Valuation Approach

In this paper we offer an explanation for why regional jets are less used in emerging economies by using a real options valuation (ROV) approach. Our ROV analysis is based on the observation that airlines are operating under different development and regulatory environments between emerging economies and developed economies. We quantify the values of the options using a case study of aircraft acquisition by airlines in the US, Brazil and China. It is found that although a theoretical value gap (a negative ROV) exists between narrow-body aircraft and regional jets (e.g., between A320 and E190) for the US carrier that operates in the condition of a low initial passenger volume per trip and a low passenger growth rate, the gap will be weaken and even become a positive ROV for the Brazilian and Chinese carriers facing a high growth rate. Furthermore, regulatory restrictions faced by Chinese carriers have a positive influence on the ROV that is biased towards narrowbody aircraft over regional jets, although this influence is less than the positive ROV impact from the high growth rate. The managerial and policy implications are also discussed.

An Option Approach to Public Infrastructure Investment

How do we ensure that public infrastructure is properly and adequately maintained and replaced? How can we ensure that the allocation of infrastructure spending is not motivated by the political process? In this paper, I present an option value approach that offers an answer to both questions and I argue that this approach is superior to the current net present value approach (NPV). This yields several important results. First, I show that the NPV approach is not sufficient. Second, the option value approach allows for an explicit valuation for comparisons between projects. Third, the option approach provides an explicit formula for managing a transportation fund for infrastructure projects. Finally, the option value approach provides the means for a rule-of-law for managing infrastructure projects that ensures that both needed investment takes place and that funding is not allocated based on political value.

Real options decision framework: Strategic operating policies for open pit mine planning

This paper presents a first approach towards the development of a dynamics decision-making tool (DDMT) for open pit mine planning projects. In this paper, a decision framework, the so-called real option decision framework (RODF), is developed based on a real-options approach with practical applicability to a mining investment project. Four strategic operating options namely, deferral options, maintain options, expand options, and shutdown options, are assumed for mining operations. We illustrated the proposed framework and developed methods for a hypothetical gold mine. The standard discounted cash flow (DCF) method was carried out to analyze the project values without options. The real option valuation (ROV) approach was calculated for the deferral and expand options. We used a system dynamics (SD) modeling method to solve real options problems and the discrete-event simulations were used to simulate the potential values of the projects. The findings are that investors are prone to lose an opportunity to invest if relying on traditional DCF-NPV rules as they suggest accepting the project if and only if NPV is greater than zero. However, results obtained from real options suggest that the project has a value to an investor across different time horizons. The insight is that it is of paramount importance to find an optimal time to exercise a strategic option. It is indicated that strategic options such as the deferral option may yield a higher value than the base case (DCF-NPV) mine option because project risks can be hedged, whereas the expand option may also offer additional value to mine operators. However, such extra-additional values can only be captured through managerial flexibility.

Overviewing the findings: the Technical Panel Review of the Pension Insurance Modeling System

AbstractThe Pension Benefit Guaranty Corporation's (PBGC) Pension Insurance Modeling System (PIMS) is used to evaluate the financial security and resilience of the national program backstopping private defined benefit plans. The Pension Research Council of the Wharton School at the University of Pennsylvania recently convened a Technical Review Panel of experts to review key inputs, outputs, and model assumptions. Our review was intended to provide a formal evaluation of the technical adequacy of the model by outside experts. The papers herein summarize views of each expert on this project. Key findings are as follows: •The PIMS models are an important and valuable tool in modeling the Pension Benefit Guaranty Corporation's liability risk. To the best of our knowledge, there is no other model that can do a comparable job.•Nevertheless, some improvements could be integrated in the Agency's approach to modeling. Those deserving highest priority attention, in the experts’ view, include incorporating systematic mortality risk (i.e., treat mortality and longevity as stochastic variables); including new asset classes increasingly found in defined benefit plan portfolios (e.g., commercial real estate, private equity funds, infrastructure, hedge funds, and others); developing a more complex model for the term structure of interest rates; and incorporating an option value approach to pricing the insurance provided.•The Agency could also do more to communicate the range of uncertainty and potential for problems associated with the PBGC's financial status. This could include additional information including the conditional value-at-risk, and perhaps an ‘intermediate,’ ‘optimistic’, and ‘pessimistic’ set of projected outcomes, as well as the expected ‘date of exhaustion’ for assets backing pension benefits insured by the PBGC.

Real option approach to evaluate cores for remanufacturing in service markets

Acquisition of cores is important for the success of remanufacturing business, but evaluating the value of cores is difficult due to many uncertain issues in the remanufacturing system. In this paper, we examine the value of cores using the real option valuation (ROV) approach, which well captures the production flexibility and represents different operations options in remanufacturing. First, in a system where the demand of remanufactured products is low, we focus on the uncertainty of price. We compare the cases where disposing cores occurs only at the expiration time and before that. The model also identifies under which circumstances disposing core early brings in more benefit. Furthermore, we study a remanufacturing system where demand and return are both uncertain. In this case, a spread option is used for evaluating the marginal value of obtaining additional cores. This approach also brings the advantage of linking the correlation between demand and return, which in fact is often exhibited in remanufacturing. The numerical experiments indicate that this correlation has an impact on collecting policies. This study illustrates the possibility of using ROV for core pricing modelling, and the study results also provide some managerial insights in managing returned cores.

Retirement, Early Retirement and Disability: Explaining Labor Force Participation after 55 in France

We analyze the influence of health and financial incentives on the retirement behavior of older workers in France, building upon Stock and Wise (1990) option value approach. The model accounts for three main retirement routes: the normal retirement, disability insurance (DI) and unemployment/preretirement pathways, and is estimated with a combination of microeconomic datasets that include the French data of the European SHARE survey. The estimates confirm that a decrease in the generosity of the pension and DI schemes induces people to stay longer in the labor market, and that people with better health tend to retire later. We present extreme situations simulating what individual's retirement behavior would have been if only one retirement route had existed and in the absence of constraints on work capabilities. We show that average years of work between 55 and 64 are nearly 14% greater when regular retirement incentives are applied to the whole population than when it is DI rules that are systematically applied.