Standard Real Options Research Articles

Optimal adaptation to uncertain climate change

Enormous public investment will occur as communities adapt to climate change. Much of this investment will be irreversible and the future benefits are uncertain. The real options embedded in adaptation projects are therefore potentially important and their existence needs to be incorporated into investment decision-making. Standard real options analysis is inadequate for this purpose because the arrival of new climate information is unlikely to conform to the stochastic processes typically used in real options analysis. This paper presents a new framework that reflects current uncertainty about climate change and how that uncertainty might change over time. Optimal investment depends on current beliefs regarding the severity of future climate change, how quickly these beliefs will change in the future, and current economic conditions. Most of the net benefits of optimal investment can be captured if investment timing is decided using a simple alternative decision-making rule.

The spirit of capitalism, investment, and consumption smoothing

We extend the standard real options approach to analyse the interdependence of investment and consumption decisions by incorporating the spirit of capitalism. For investment, when investment payoff is given as a lump-sum payment, the spirit of capitalism erodes the option value to invest and speeds up investment. However, for a flow investment payoff, the spirit of capitalism encourages the agent to postpone investing since the project value after investment is less than the option value before investment. The results on the investment timing are robust to alternative specifications of the payoff process. For consumption, the agent tends to consume less in the presence of the capitalist spirit. Finally, the time-series properties of consumption and welfare implications of the spirit of capitalism are analysed.

Optimal Sequential Investment Decision-Making with Jump Risk

This paper uses the real-option approach to find the optimal amount and time of investment in a real project. This approach is better than the net present value approach because it captures the uncertainty in the future expected cash flow. The real option has been applied to many industries; for example, oil and gas, telecommunications, and large-scale energy projects. The model introduced in this paper adds two features to the standard real options. The first feature is the two-stage investment. In reality, it is common for the project manager to not invest all budget at once. The second feature is the early termination event. The finding is that such a sudden death event causes the waiting period to be longer for both one-stage and two-stage investments. With low volatility, the lower optimal investment proportion of the total project budget is expected, when the mean arrival rate of the jump downside risk is higher. With medium or higher volatility, the higher optimal proportion is associated with a higher probability of jump risk. When the rate of one-time event is constant, volatility increases the optimal investment amount and increases the waiting time. The project has more value when the investment is divided into two stages rather than one stage. All other things being equal, the waiting time of one-stage is shorter than the waiting time of the first stage but longer than that of the second stage.

The dynamics of preemptive and follower investments with overlapping ownership

We study how overlapping ownership affects investments in a preemption race with market uncertainty. Internalization of rival payoffs delays follower entry if product market effects are moderate, implying longer incumbency which intensifies the race to lead. Preemptive and follower investment thresholds increase with volatility as in standard real option models but firm value can decrease, and greater volatility makes internalization more profitable. From a welfare perspective there is a tradeoff between a dynamic benefit and a static cost of overlapping ownership. Whereas it is socially optimal not to have any overlapping ownership in some markets, at low volatility levels we find firms have an insufficient incentive to internalize.

The price-bidding strategy for investors in a renewable auction: An option games–based study

This paper presents a preemption game model based on real option theory to analyze the optimal bidding price for investors participating in a renewable auction. We studied how investors each decides their own optimal bidding price, with preemption by rivals and incomplete information, to balance their expected profits and ability to hedge risk. We demonstrate that adjusting the bidding price to hedge the risks from adverse market conditions can equal that of choosing a flexible investment time based on the standard real option model. The unique Bayesian Nash equilibrium of the game constituted with the optimal bidding price of each investor is also characterized. The quantitative solution to the model is provided, with integration of least squares Monte Carlo, and in the case study we calculate the optimal bidding price of offshore wind power concessions in China. An interesting finding in the quantitative evidence is that, although the optimal bidding price is close to zero net present value if the number of participants is large, with consideration of risk-hedging ability, investors may tend to play a hostile bid, which shows that a large number of participants may do harm to some renewable projects that are not mature enough.

Risk aversion and urban land development options

AbstractThis study empirically tests the volatility effects on land development options using the Singapore's government land sales data from 1996 to 2018. We find that development land option premiums increase by 5% on average with one standard deviation increase in conditional volatility, which is consistent with the prediction of the standard real options model. However, the high volatility effects on development options are negative in an extremely high volatility state, and risk‐averse developers exercise development options earlier than that predicted by the risk‐neutral model. The reduction in real option premium in an extremely high volatility state is not explained by market competition and risk‐mitigating mechanism. The results reveal the real estate developers’ behavior change in different states of market volatility.

The Dynamics of Investments With Overlapping Ownership

We study how overlapping ownership affects investments in a preemption race with market uncertainty. Internalization of rival payoffs delays follower entry if product market effects are moderate, implying longer incumbency which intensifies dynamic competition. Preemptive and follower investment thresholds increase with volatility as in standard real option models whereas firm value can decrease, and greater volatility makes internalization more profitable. From a welfare perspective there is a tradeoff between dynamic benefit and static costs of overlapping ownership. Whereas it is socially optimal not to have any overlapping ownership in some markets, at low volatility levels we find firms have an insufficient incentive to internalize.

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)

Green electricity investments: Environmental target and the optimal subsidy

We investigate the optimal investment decision in renewables under market demand uncertainty, in the context of the Italian strategy for renewable deployment under the EU policy. The firm has to decide about the time and size of the investment. We find that a higher subsidy level induces the firm to invest earlier with a smaller investment capacity. This implies that a given environmental target cannot be reached by a too high (too low) subsidy level since this will cause the investment level to be too low (too late). We show that there exists an optimal (intermediate) subsidy level. Due to uncertain demand, in some cases ensuring to reach the environmental target in time requires an additional (conditional) subsidy. We propose a heuristic for policy makers stating when and how much subsidy to provide. Furthermore, we find that in a more uncertain economic environment the subsidy adjustment to maintain the target level of investment results in the firm investing earlier, which is opposite to the standard real options result.

Model risk in real option valuation

We introduce a general decision-tree framework to value an option to invest/divest in a project, focusing on the model risk inherent in the assumptions made by standard real option valuation methods. We examine how real option values depend on the dynamics of project value and investment costs, the frequency of exercise opportunities, the size of the project relative to initial wealth, the investor’s risk tolerance (and how it changes with wealth) and several other choices about model structure. For instance, contrary to stylised facts from previous literature, real option values can actually decrease with the volatility of the underlying project value and increase with investment costs. And large projects can be more or less attractive than small projects (ceteris paribus) depending on the risk tolerance of the investor, how this changes with wealth, and the structure of costs to invest in the project.

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.

Green Electricity Investments: Environmental Target and the Optimal Subsidy

We investigate the optimal investment decision in renewables under market demand uncertainty, in the context of the Italian strategy for renewable deployment under the EU policy. Upon investing, the firm has to decide about the time and size of the investment. We find that a higher subsidy level induces the firm to invest earlier with a smaller investment capacity. This implies that a given environmental target cannot be reached by a too high (too low) subsidy level since this will cause the investment level to be low (too late). We show that there exists an optimal (intermediate) subsidy level to reach the environmental target. Furthermore we find that in a more uncertain economic environment the subsidy adjustment to maintain the target level of investment results in the firm investing earlier, which is opposite to the standard real options result.

Capacity optimization under uncertainty: The impact of operational time lags

Time lags in switching operational modes are typical in the manufacturing and power sectors but are not treated in most real options models. In this paper, we consider a firm that has the opportunity to suspend and to resume production infinitely many times subject to a time lag after each startup decision. We contribute to the literature by allowing the firm to determine its level of installed capacity in conjunction with its optimal investment timing. We find that an increase in the length of the time lag results in an increase in the optimal capacity level. Capacity optimization also interacts with the length of the time lag to affect investment timing and the triggers to suspend and resume production, thereby weakening the result about hysteresis from a standard real options model. Under the assumption of a fixed level of capacity, a longer lag speeds up the decision to resume operations due to a positive upside to the revenue but delays the suspension of operations. By contrast, with capacity optimization, a longer time lag results in a larger capacity choice, which can indirectly delay the investment decision and the timing to resume operations. This indirect effect dominates when the level of market uncertainty is low and the time lag is initially small.

Strategic real option and flexibility analysis for nuclear power plants considering uncertainty in electricity demand and public acceptance

Nuclear power is an important energy source especially in consideration of CO2 emissions and global warming. Deploying nuclear power plants, however, may be challenging when uncertainty in long-term electricity demand and more importantly public acceptance are considered. This is true especially for emerging economies (e.g., India, China) concerned with reducing their carbon footprint in the context of growing economic development, while accommodating a growing population and significantly changing demographics, as well as recent events that may affect the public's perception of nuclear technology. In the aftermath of the Fukushima Daiichi disaster, public acceptance has come to play a central role in continued operations and deployment of new nuclear power systems worldwide. In countries seeing important long-term demographic changes, it may be difficult to determine the future capacity needed, when and where to deploy it over time, and in the most economic manner. Existing studies on capacity deployment typically do not consider such uncertainty drivers in long-term capacity deployment analyses (e.g., +40years). To address these issues, this paper introduces a novel approach to nuclear power systems design and capacity deployment under uncertainty that exploits the idea of strategic flexibility and managerial decision rules. The approach enables dealing more pro-actively with uncertainty and helps identify the most economic deployment paths for new nuclear capacity deployment over multiple sites. One novelty of the study lies in the explicit recognition of public acceptance as an important uncertainty driver affecting economic performance, along with long-term electricity demand. Another novelty is in how the concept of flexibility is exploited to deal with uncertainty and improve expected lifecycle performance (e.g. cost). New design and deployment strategies are developed and analyzed through a multistage stochastic programming framework where decision rules are represented as non-anticipative constraints. This approach provides a new way to devise and analyze adaptation strategies in view of long-term uncertainty fluctuations that is more intuitive and readily usable by system operators than typical solutions obtained from standard real options analysis techniques, which are typically used to analyze flexibility in large-scale, irreversible investment projects. The study considers three flexibility strategies subject to uncertainty in electricity demand and public acceptance: 1) phasing (or staging) capacity deployment over time and space, 2) on-site capacity expansion, and 3) life extension. Numerical analysis shows that flexible designs perform better than rigid optimal design deployment strategies, and the most flexible design combining the above strategies outperforms both more rigid and less flexible design alternatives. It is also demonstrated that a flexible design benefits from the strategies of phasing and capacity expansion most significantly across all three strategies studied. The results provide useful insights for policy and decision-making in countries that are considering new nuclear facility deployment, in light of ongoing challenges surrounding new nuclear builds worldwide.

Competition and Learning in Real Options

We study a product development race by introducing competition under private information in an otherwise standard real-options environment. Firms observe the stochastic evolution of their own potential payoffs from entry into a market, while forming conjectures about the state of their opponents. They face a trade-off between immediate entry or delay, in which the costs of waiting are enhanced by the endogenous threat of preemption by a rival. We characterize Markov Perfect Equilibria through a coupled system of differential equations: forward-looking value functions determine optimal exercise rules, while backward-looking beliefs determine the probability of an opponent's exercise. The equilibrium displays an intensity of competition that first builds up, then subsides slowly towards a steady-state. We additionally compute the equilibrium and illustrate some of its qualitative properties, such as the long-lived transient dynamics and the consequences of heterogeneity between competitors.

An approach for analyzing and managing flexibility in engineering systems design based on decision rules and multistage stochastic programming

ABSTRACTThis article introduces an approach to assess the value and manage flexibility in engineering systems design based on decision rules and stochastic programming. The approach differs from standard Real Options Analysis (ROA) that relies on dynamic programming in that it parameterizes the decision variables used to design and manage the flexible system in operations. Decision rules are based on heuristic-triggering mechanisms that are used by Decision Makers (DMs) to determine when it is appropriate to exercise the flexibility. They can be treated similarly as, and combined with, physical design variables, and optimal values can be determined using multistage stochastic programming techniques. The proposed approach is applied as demonstration to the analysis of a flexible hybrid waste-to-energy system with two independent flexibility strategies under two independent uncertainty drivers in an urban environment subject to growing waste generation. Results show that the proposed approach recognizes the value of flexibility to a similar extent as the standard ROA. The form of the solution provides intuitive guidelines to DMs for exercising the flexibility in operations. The demonstration shows that the method is suitable to analyze complex systems and problems when multiple uncertainty sources and different flexibility strategies are considered simultaneously.

The effects of an uncertain abandonment value on the investment decision

Using a three-factor stochastic real option model framework, this paper examines the effects of abandonment on the investment decision. Abandonment is classified according to whether the opportunity arises for an active operating asset post-investment, or for holding the project opportunity pre-investment. Separate analytical models are developed for the alternative forms of abandonment optionality. Numerical sensitivity analysis shows that the presence of a post-investment abandonment opportunity makes the investment opportunity appear to be more attractive because of the abandonment option value, but not by a considerable amount. Also, in contrast to the standard real option finding, an abandonment value volatility increase produces a project value threshold fall owing to the increase in the abandonment option value.

Product market competition, R&D investment, and stock returns

A standard real options model predicts a strong positive interaction effect between research and development (R&D) investment and product market competition. R&D-intensive firms tend to be riskier and earn higher expected returns than R&D-weak firms, particularly in competitive industries. Also, firms in competitive industries earn higher expected returns than firms in concentrated industries, especially among R&D-intensive firms. Intuitively, R&D projects are more likely to fail in the presence of more competition because rival firms could win the innovation race. Empirical evidence largely supports the model׳s predictions.

Alertness, Leadership, and Nascent Market Dynamics

In a continuous-time model with uncertain market development, two potential entrants detect a nascent demand only if it reaches a firm-specific threshold. Entry occurs by investing irreversibly before competing in quantities. When leadership in the investment stage implies a first-mover advantage in the market stage, we examine how the firms’ relative “alertness” drives the equilibrium outcomes. If the firms detect the new demand relatively late, the entry strategies and resulting firm values differ qualitatively from those in standard real option games: (1) In case of symmetric detection, the probability of simultaneous entry is nonzero, and can be one, although demand is still nascent. When sequential entry occurs, there is no rent equalization, with the post-entry market advantage, resulting in higher equilibrium expected value to the leader; (2) in case of asymmetric detection, entry is always sequential, and the more alert firm maximizes value by delaying its investment to enter exactly when its short-sighted rival detects demand. The marginal effect of the market advantage on the leader’s equilibrium value increases in the inter-firm alertness differential; and (3) more demand volatility reduces the value differential across firms and makes less likely the impact of imperfect alertness on entry decisions.

Cumulative Leadership and Entry Dynamics

In a continuous-time model with uncertain market development, two potential entrants detect a nascent demand only if it reaches a firm specific threshold. Entry occurs by investing irreversibly before competing in quantities. When leadership in the investment stage implies a first-mover advantage in the market stage, we examine how the firms' relative drives the equilibrium outcomes. If the firms detect the new demand relatively late, the entry strategies and resulting firm values differ qualitatively from those in standard real option games: (i) In case of symmetric detection, the probability of simultaneous entry is nonzero, and can be one, although demand is still nascent. When sequential entry occurs there is no rent equalization, with the post-entry market advantage resulting in higher equilibrium expected value to the leader; (ii) In case of asymmetric detection, entry is always sequential, and the more alert firm maximizes value by delaying its investment to enter exactly when its short-sighted rival detects demand. The marginal effect of the market advantage on the leader's equilibrium value increases in the inter-firm alertness differential; (iii) More demand volatility reduces the value differential across firms, and makes less likely the impact of imperfect alertness on entry decisions.