Real Options Literature Research Articles

Strategic investment under uncertainty: why multi-option firms lose the preemption run

We consider a dynamic duopoly game where firms choose both the timing and size of their investments. The existing real options literature predominantly consists of contributions where firms have a single option to invest. This paper relaxes this assumption by giving Firm A multiple options to undertake further investments with the purpose to expand whereas Firm B only holds the option to enter the market. In this asymmetric setting we get the surprising result that, in equilibrium, Firm B invests first. If Firm A invests first, Firm A and Firm B keep on being involved in preemption games for subsequent investments until Firm B enters the market, which leads to inefficiently early investments of Firm A. When Firm B invests first, then only one preemption game is played, which leads to Firm A being free to choose its unrestricted optimal investment moments.

Valuation of Infrastructure Projects: Review of the Real Options Literature

Given the infrastructure sector development and the worldwide trend to grant infrastructure projects to private investors, a growing number of articles in the literature have been devoted to the issue of evaluating this class of investments. To consider the risk and irreversibility of infrastructure investments, researchers have resorted to the real options approach (ROA), which captures the value of managerial flexibility under uncertainty. This article analyzes the research focus, trends, and design found in the literature devoted to the ROA in infrastructure concession project valuation. The results are presented in a quantitative form. They provide insights that may be of value to researchers, project developers, and policymakers who intend to plan and evaluate infrastructure concession projects.

A cognitive perspective on real options investment: CEO overconfidence

AbstractResearch SummaryWhile real options theory has been applied with the optimality assumption, actual real options investments are made by managers, who are subject to cognitive biases, especially under uncertainty. In this article, we focus on one important type of cognitive bias, overconfidence, to provide new insights on real options literature. We argue that overconfident CEOs will invest less in real options than non‐overconfident CEOs. We also predict that the relationship between overconfident CEOs and firms' real options intensity will be strengthened when market uncertainty is higher. In a study of U.S. public firms, we find strong support across various tests that use multiple measures of overconfidence in CEOs and real options investments, and control for potential selection issues and other endogeneity concerns.Managerial SummaryThis article studies how a CEO's cognitive bias, overconfidence, may shape a firm's real option investments, which could result in a different level of strategic flexibility. We argue that overconfident CEOs have overly high expectations of their performance under uncertainty and/or underestimate the level of uncertainty in their strategic decision‐making, which leads to lower investments in the firms' real options relative to non‐overconfident CEOs. We study a sample of U.S. public firms and find strong evidence that an overconfident CEO is positively related to the real options investments at the firm level. We also find that this overconfidence effect becomes more pronounced in markets with greater uncertainty.

Demand uncertainty, product differentiation, and entry timing under spatial competition

We investigate entry timing and product position decisions with market size uncertainty under continuous-time Hotelling type spatial duopoly competition. We show how entry timing and product position interact under uncertainty. The expected result under real options holds: the leader’s entry threshold monotonically increases with volatility, which means that the leader abandons earlier period monopoly profits, which are not so time discounted. The significant findings are as follows: First, from the expected result, the larger the abandoned monopoly profits in earlier periods through volatility, the closer to the edge the leader’s product position. Second, this property of the leader’s decision regarding its product position makes the follower’s entry threshold non-monotonic with a positive correlation to volatility, in contrast to previous studies in the real options literature. The above two results have an important implication: the leader values the abandoned monopoly profits in earlier periods through volatility more than the highly increased monopoly profits in later periods through delayed entry by the follower.

A bi-level model for optimal capacity investment and subsidy design under risk aversion and uncertainty

Meeting ambitious sustainability targets motivated by climate change concerns requires the structural transformation of many industries and the careful alignment of firm- and Government-level policymaking. While private firms rely on Government support to achieve timely the necessary green investment intensity, Governments rely on private firms to tackle financial constraints and technology transfer. This interaction is analysed in the real options literature only under risk neutrality, and, consequently, the implications of risk aversion due to the idiosyncratic risk that green technologies entail are overlooked. To analyse how this interaction impacts a firm’s investment policy and a Government’s subsidy design under uncertainty and risk aversion, we develop a real options framework, whereby: (i) we solve the firm’s investment problem assuming an exogenous subsidy; (ii) conditional on the firm’s optimal investment policy, we address the Government’s optimisation objective and derive the optimal subsidy level; (iii) we insert the optimal subsidy level in (i) to derive the firm’s endogenous investment policy. Contrary to existing literature, results indicate that greater risk aversion lowers the amount of installed capacity yet postpones investment. Also, although greater uncertainty raises the optimal subsidy under risk neutrality, the impact of uncertainty is reversed under high levels of risk aversion.

Real options appraisal of forestry investments under information scarcity in biomass markets

Technology projects involve the acquisition and development of assets with different natures, such as infrastructure and application software, which might have little value unless other assets are present. Even when the benefits associated with a particular asset can be isolated, they involve a high degree of uncertainty, because their execution is affected by several organizational aspects. The multiple choices necessary for the project development imply different phases and cost schemes, so choosing among these choices has implications for the options available for the project manager once the project has started.Assuming a market environment with scarce information, irreversible investment expenditures, and uncertainty in demand, our paper determines a given implied utilization of the production capacity, that cannot be adjusted later. Facing the indicated environment one major problem arises: defining the optimal implied utilization capable of maximizing the option value of investing. Considering a multi-phase forestry investment project, which comprehends a seed and an expanded investment, complemented with a Kalman filter, our study includes a closed-form solution to estimate the optimal level of implied utilization.This paper provides a structure that estimates the critical values of seed capital forestry investment for technology-based projects, mitigating the risk and scheduling the investment efficiently. It intends to validate a two-phase real options tangible forestry investment model, assuming a seed forestry investment with a reducing effect over the uncertainty management. Thus, by exploring this effect, the model provides the optimal implied utilization and determines the suitable volume of seed capital required to maximize the forestry investment option. It contributes to extending the real options literature by linking forestry investment with implied utilization.

Firm-level effects of staged investments in innovation: The moderating role of resource availability

Integrating insights on firms’ resource availability with bounded rationality and real options arguments, we propose that resource-abundant and resource-constrained firms reap different effects from a staged approach to innovation. We argue that resource availability triggers overoptimism and managerial discretion, and thereby impedes adequate resource reallocation in staged innovation projects, leading to different effects of staging at the firm level. An empirical analysis of 2,790 German firms confirms that a staged investment approach leads to a higher number of newly started and abandoned innovation projects in resource-abundant firms than in resource-constrained firms. Supplementary analyses suggest that this is indeed because resource-abundant firms demonstrate more overoptimism and managerial discretion. We discuss implications for the real options literature, as well as managerial implications for innovation investment decisions.

To Wait or Not to Wait? Use of the Flexibility to Postpone Investment Decisions in Theory and in Practice

Business sustainability and real options are closely connected, as real options are managerial flexibility that allows organizations to adapt to changes in their environment, thus making the organization more robust and economically sustainable. Studies in real options theory abound, yet there is still a lack of evidence on whether people make decisions consistently with the predictions made by real options models. We run a laboratory experiment to study the role of option value and the laboratory time required to resolve uncertainty in individuals’ decision to price and adopt an option to wait. Specifically, we compare decision makers’ choices in two investment scenarios: One with a short time to maturity (implying a low option value), and another with a longer time to maturity (implying a high option value). In the lab, both scenarios are implemented with the waiting time of twenty and sixty minutes. Our results show that decision makers deviate from the theoretical predictions, recognizing the benefit of waiting, when the value of the option is higher, or when the waiting time is shorter. Our study does not only bring more insights into real options adoption at the individual level, but also emphasizes the great potential of behavioral and experimental approach to bridge the gap between theory and practice in the real options literature.

Real option applications in megaproject planning: trends, relevance and research gaps. A literature review

ABSTRACT Megaprojects are complex and contain multiple risks and uncertainties. The dominant ‘predict and control’ planning method mainly ignores risks and uncertainties, making megaprojects inflexible and vulnerable to unforeseen changes. Insights and methods from real options theory (ROT) in economics and finance have the potential to improve planning of megaprojects in three ways: (a) better management and assessment of risks and uncertainties, (b) a more transparent and explicit identification and communication of risks and uncertainties, and (c) a monetary valuation of flexibility. An in-depth literature review of 42 papers of real options applications to megaprojects serves as a benchmark to analyse if current real options literature meets these three expectations. Through this review, we identify the main trends, relevance and research gaps. While its theoretical relevance is illustrated, three main gaps impede real options’ practical relevance for megaprojects: the applications paint an incomplete picture of megaprojects; its mathematical complexity; and the lack of empirical evidence of real-life cases. Based on a plea for more interactive research between scholars and planning practitioners, we provide an agenda for further research as to how ROT can better meet its expectations and fulfill its potential for the planning of megaprojects.

Public–private equity joint ventures and risk transfers in motorways of the sea

PurposeThe purpose of this paper is to present a new scheme of public–private partnership (PPP) within the framework of motorways of the sea (MoS) similar to that of an equity joint venture along with a methodology for valuing risk transfers arising from options embedded in the clauses included in such agreement.Design/methodology/approachThe architecture of the proposed PPP is an adaptation to the scope of a MoS of collaborative schemes commonly used in industry such as equity joint ventures. The methodology for valuing options involved making use of a valuation tree of optimal cashflows along with algorithm designs from the field of financial and real options.FindingsThe proposed structure of public–private equity joint venture (PPEJV) increases the stability of private–public collaboration as compared with standard PPPs, so as to achieve the desired modal shift. The analyzed case study shows how the methodology provides valuable numerical information for both negotiating partners and policy makers.Practical implicationsThis study provides a quantitative tool for policy makers to redefine the role that public agents and public funds should play in a future sustainable mobility model.Originality/valueThe originality of the authors’ contribution to the field of PPPs in transport is triple. First, there is no precedent in the literature on PPPs of an architecture similar to that of the proposed PPEJV. Second, unlike the usual practice in the valuation of financial or real options, no prior structure is assumed for modelling the behaviour of cashflows. Third, the type of options addressed is not usual neither in the real options literature in general nor in the valuation of guarantee mechanisms included in PPPs in particular.

R&D Investment timing, default and capital structure

This paper investigates the interaction between R&D investment timing, probability of default, and capital structure. In particular we are interested in studying the investment behaviour of three different types of firms according to their capital structure: firms that only use internal funds as a source of funding (unlevered), firms that use debt and that are able to attract unlimited amount of funds (levered unconstrained) and finally firms that use debt, but are not able to attract all the amount needed (levered constrained). We consider irreversible investments in R&D with uncertain returns, financed through debt. We show that debt financing (with or without constraints) significantly alters the standard results in the real option literature. First, we show that leverage distorts the investment threshold and shareholders of a levered firm tend to accelerate investment with respect to an all equity financed firm. This finding is explained by the fact that the increase in the probability of default, which is positively correlated with leverage, might induce a potential loss of the investment option and thus reduce the value of the option to wait providing equity holders with an incentive to speed up the investment. Second, if we introduce the financial constraint, the investment threshold is characterized by a U-shaped relation. The latter implies that the investment threshold diminishes as the financial constraint becomes less stringent, but up to a certain minimum value. After a certain amount of leverage the firm attitude towards R&D investment changes. The firm becomes more risk adverse, given the much higher probability of default (linked to a much higher leverage in its balance sheet).

The case of public and private ports with two actors: Capacity investment decisions under congestion and uncertainty

Since port capacity investments involve expensive large projects with high uncertainty and irreversibility, we use real options calculations to study the optimal size and timing of the investment decision in new port capacity. This paper focuses on container port cases where the managing port authority (PA) is responsible for the investment in infrastructure on the one hand. On the other hand, the terminal operating company (TOC) that obtained a concession from the PA to handle the containers, invests in the superstructure. Moreover, the PA is often partly or fully publicly owned, leading to the consideration of social welfare among its objectives. Examples of such container ports include Gioia Tauro in Italy when it was developed, and the port of Luanda in Angola. In the type of ports considered, the PA’s strategy could be to urge the TOC to invest in the PA’s individual optimum. When a share of the PA is owned publicly, social welfare is to be considered in the maximisation. In this light, the PA and the TOC could agree to invest at the service ports’ single actor optimum and redistribute the additional aggregate gains. Higher public involvement leads to a larger investment that is also made earlier, augmenting benefits generated by the port. This relationship between investment size and timing is exceptional in the real options literature. Moreover, the investment decision is complicated by the fact that port users are averse to congestion and the costs it involves. When this cost or uncertainty is higher, it is found that more capacity will be installed, but at a later moment.

CEO Overconfidence and Strategic Flexibility:Evidence from Real Options Investment

While real options theory has been applied with the rationality assumption, the actual real options investments are made by managers, who are often subjective to cognitive biases, especially under uncertainty. In this paper, we focus on one important type of cognitive bias, overconfidence, to provide new insights on real options literature. We argue that an overconfident cognitive bias will impede CEOs from effectively evaluating the magnitude of the uncertain environments and/or will make them overestimate their capability to perform under uncertainty, resulting in CEOs investing less in firm-level strategic flexibility. Hence, we predict that overconfident CEOs will invest less in real options than other CEOs. We also predict that the relationship between overconfident CEOs and firms’ real options intensity will be strengthened when market uncertainty is higher. We test our arguments using a sample of US public firms covering the 17-year period from 1997 to 2013. We find strong support across various tests that use multiple measures of CEO overconfidence and real options intensity and control for potential selection issues and other endogeneity concerns.

Sequential Investment and Time to Build

Real world investment decisions are generally made sequentially, over time. Management must consider the possibility of subsequent decisions like suspending a project when an initial investment decision is made. This consideration seems to be particularly important in the case of investments, which take a long time to build. In this paper, I analyze the impact of lags between the initial investment decision and the completion of the project. I also analyze in a dynamic setting under uncertainty the impact on the investment value of the option to suspend investment or operations and the investment threshold. I show that the standard net present value rule works well within my framework. This result contrasts with the main results in most of the real options literature. I use my model to value the length of permit procedures for locational decisions.

Compound option pricing under a double exponential Jump-diffusion model

A compound option, an option on another option, plays an important role in financial field since it can be used to price American option and corporate debt with discrete coupons. In the real options literature, compound options are most suitable to be employed to investment problems involving sequential decision making. Most compound option and real options formulae are based on log-normal distribution while the empirical evidence shows that the return distribution in real market exhibits asymmetric leptokurtic feature, higher peak and two heavier tails. This paper introduces the jump-diffusion process into pricing compound options and derives the related valuation formulas. We assume that the dynamic of the underlying asset return process consists of a drift component, a continuous Wiener process and discontinuous jump-diffusion processes which have jump times that follow the compound Poisson process and the logarithm of jump size follows the double exponential distribution proposed by Kou (2002). Numerical results indicate that the advantage of combining the double exponential distribution and normal distribution is that it can capture the phenomena of both the asymmetric leptokurtic features and the volatility smile. Furthermore, the compound options under the double exponential jump diffusion model which we derived are more generalized than those proposed by Gukhal (2004) and Geske (1979), and thus have wider application.

Demand Uncertainty, Product Differentiation, and Entry Timing Under Spatial Competition

We investigate the decision of entry timing and product positions under market size uncertainty with Brownian motion for continuous-time spatial duopoly competition. We show the following results. First, the leader is more likely to increase the degree of product differentiation as volatility increases and to decrease it as volatility decreases. Second, the entry threshold of the follower non-monotonically increases in volatility, which is in contrast to previous studies in the real options literature. Finally, a more significant entry cost asymmetry between firms places the leader closer to the edge in a preemptive-entry equilibrium and closer to the center in a sequential-entry equilibrium.

Comparative statics for real options on oil: What stylized facts?

ABSTRACTAn important application in the real options literature has been in investments in the oil sector. Two commonly applied “stylized facts” in such applications are tested here. One is that the correlation of the returns on oil and the stock market is positive; the other that it is invariant to changes in oil price volatility. Both are rejected in data for 1993–2008 for crude oil and Standard & Poor's 500 stock market index. Based on real options theory, consequences are pointed out. The widespread idea that higher volatility leads to increased value and postponed investment is not necessarily valid.

Considering real options in short-term decision making

Option-like situations in non-financial markets, often referred to as real options, are usually discussed and analyzed in the context of investment decisions. In spite of the real options literature’s focus on investment decisions, option-like situations are also frequently encountered in operating decisions. For instance, decisions on the operating mode of a flexible machine in the presence of switching costs can be characterized as complex real options problems with multiple compound options. For an optimal long-term solution, short-term decision rules must consider the value of these options. In this paper we first show how a fully rational decision rule that takes the long-term consequences of short-term decisions into account can be derived within the real options framework. We contrast the outcomes of decisions according to this benchmark rule with the outcomes of decisions according to the traditional decision rule based on current contribution margin and illustrate our findings with a simulation analysis providing for a rich set of environments characterized by different levels of uncertainty and different switching costs. A major drawback of the options-based rule is the necessity to estimate option values at every decision point drawing on information from all future periods. We therefore analyze how a simplified options-based decision rule that looks ahead only one period performs against the benchmark rule. In an extension of the simulation analysis we find that the simplified decision rule serves as a good heuristic and improves decision-making similar to the benchmark rule while at the same time being much more likely to be implemented in practice.

Staged Investments in Innovation: A Behavioral Perspective on Real Options and Portfolio Composition

Building on real options literature and the behavioral theory of the firm, this study investigates the impact of a staged investment approach to innovation on firms’ project portfolio composition, ...

Introduction to the Special Issue on Industrial Organization

Dynamic games have proven to be a natural and powerful tool in modeling and understanding a number of important phenomena in industrial organization. This framework allows for a parsimonious modeling of market interactions over time, when at least some of the economic agents are non-atomic and decisions at a given moment impact the nature of market competition in the future in a way captured by natural state variables. A key feature of this setting is that, being cast most often in infinite-horizon models, dynamic games avoid endof-horizon effects that can easily condition conclusions obtained with finite-horizon models, in particular with the two-stage paradigm commonly used in industrial organization. This special issue contains both original articles and reviews of important recent strands of literature dealing with the application of the dynamic games paradigm in industrial organization, broadly defined. The theory of real options initiated in the seminal book by Dixit and Pindyck [5] is a powerful tool to examine the timing of lumpy irreversible investment. Huberts, Huisman, Kort and Lavrutich review a recent strand of the real options literature where decision makers choose both the timing and the size of the investment. This is an important extension that shows that, while the general wisdom that more uncertainty diminishes the value of waiting remains true, more uncertainty may also generate larger investments: Uncertainty may not hurt growth. An important and common feature in the real options literature is that the firms are assumed to be aware of an investment opportunity at all points in time. Bruno Versaevel examines an original research question related to irreversible lumpy investment: Firms do