Theoretical Real Options Research Articles

Vertical integration: a real options approach

ABSTRACT We develop a theoretical real options model and explore the trade-off between vertical integration and external procurement. In contrast to transaction cost theory, we show that higher volatility in the downstream market reduces the likelihood to switch to internal production. We also analyse the decision to acquire the supplier and provide novel predictions on the acquisition likelihood and premium contributing to studies relating to vertical M&As.

From theoretical real options models to pragmatic decision making: Required steps, opportunities and threats

Port capacity investments are large, irreversible and uncertain projects, involving different decision variables to be optimised. In order to optimise the timing and size of such projects, the literature has indicated that real options (RO) are better suited than the more traditional net present value (NPV) approach. The models are very theoretical and difficult to implement in practice. The objective of this paper is to extend the empirical RO literature in transportation and logistics by bringing continuous-time continuous-state RO models closer to practitioners. This is done by means of developing a blueprint for a practical software application through which port investment managers can easily calculate their optimal decisions. Additionally, the blueprint of this practical implementation allows for a better understanding of the continuous RO logic and way of working. As the discussion of the RO advantages shows, optimising the decision through continuous RO models, rather than applying NPV, can allow ports to realise a much better investment and generate a lot more value from port investment projects. Nevertheless, depending on the specific situation, practitioners might require supplementary assistance of econometricians or consultants to estimate the RO model input parameters. This paper also adds to the literature by quantifying these potential gains and costs.

Symmetric equilibrium strategies in game theoretic real option models with incomplete information

This paper considers a real options model with incomplete information in a duopoly setting. I show that even in the presence of a first-mover advantage, there are circumstances in which the preemption region is eroded entirely and the only equilibrium strategy is of simultaneous-type: both players should exercise together or not at all. This outcome arises if the price paid by a player from exercising the option simultaneously with his competitor (over exercising alone as a Stackelberg leader) is low. Such an outcome has not been previously recognised in the literature. The underlying information structure has been applied in a one-firm setting to a range of different contexts of late, all of which have competitive pressures in practice. As such, the existence of this equilibrium under certain conditions ought to be recognised.

Developers’ heterogeneity and real estate development timing options

PurposeThe purpose of this paper is to examine developers’ optimal development timing when developers are heterogeneous and have different marginal costs in a real estate development market.Design/methodology/approachThis study uses a multiple-player game theoretic real option model and provides tractable results of asymmetric development strategies from a two-stochastic-variable model. Anecdotal evidence and market observations are presented.FindingsStronger developers (with low marginal costs) exercise real estate development options earlier than weaker developers (with high marginal costs). However, the interval time between developments by stronger and weaker developers decreases in rental volatilities. Real estate with a high positive externality are developed earlier than real estate with a low or negative externality.Practical implicationsWeaker and smaller developers are advised to undertake projects having positive externalities from vicinities. Government agencies are recommended to use tools of zoning and urban planning to prioritise developments introducing positive externalities and to facilitate the growth of weaker and smaller developers. This may subsequently help reduce incentive for land banking and oversupply in real estate space market.Originality/valueThis research is probably the first to explicitly incorporate developers’ heterogeneous strength in real estate development timing options with multiple developers in a competitive market. It sheds additional insights into the understanding of potential problems of development cascades, under the interactive effects between exogenous policy changes and endogenous response from asymmetric developers.

A Game Theoretical Real Options Framework for Investment Decisions in Mobile TV Infrastructure

This work presents a strategic investment framework for mobile TV infrastructure. We address the question of whether an operator should enter the mobile TV market and, if yes, how and when to do so. We perform a capacity and QoS analysis that shows that Mobile TV is not a simple added-on service but requires new planning strategies that need heavy investments. We consider two possible settings: a competitive mobile TV network where a digital video broadcasting (DVB) operator and a cellular network operator build their independent networks and a cooperative setting where the TV network is mainly relying on a DVB infrastructure whose coverage can be complemented by a cellular network. Two main issues alter the investment decision of the stakeholders, namely, the market uncertainty and the competition or the willingness of cooperation between the main technological players. We define a game theoretical real options framework and propose a novel bi-level dynamic programming algorithm that solves the underlying profit maximization problem. Our numerical results illustrate the optimal investment decisions of both actors and the impact of the system parameters as well as the degree of uncertainty on the investment dates.

A review of real options approaches: applying models to value a medical device project

A number of practical real options approaches in literature, some of which have been embraced by industry, lack financial rigour, while many theoretical approaches are not practically implementable. Industry surveys reveal that managers are reluctant to apply some of the more theoretical real options approaches due to their lack of transparency, their complexity, and because of the lack of firm acceptance and top management support. In this paper we compare and contrast five real options approaches designed for managers and apply each to value a medical device product development project. The medical device project is modelled as a compound call option, and the results are contrasted to a traditional NPV calculation. Issues of volatility estimation and the possibility of arbitrage opportunities in the pricing procedures are examined.

The Impact of Ambiguity on Managerial Investment and Cash Holdings

AbstractStandard finance theory suggests that managers invest in projects that, in expectation, produce returns that justify the use of capital. An underlying assumption is that managers have the information necessary to understand the distributional properties of the pay‐offs underlying the decision. This paper examines firm investment behavior when managers are likely to find it more challenging to develop expectations of pay‐offs, namely during periods of increased macroeconomic ambiguity. In particular, we examine how macroeconomic ambiguity – proxied by the variance premium (Drechsler, ) and the dispersion in forecasts of corporate profits from the Survey of Professional Forecasters (Anderson et al., ) – impacts managerial capital investment and cash holdings. Consistent with ambiguity theory, we find that macroeconomic ambiguity is negatively associated with capital investment and positively associated with cash holdings. These results are robust to alternative explanations related to risk, investor sentiment and economic conditions. Moreover, consistent with recent theoretical real options literature, we find that ambiguity reduces the value of investment opportunities, while risk increases the value of such opportunities. Overall, these findings provide initial empirical evidence on the economic distinction between ambiguity and risk with respect to managerial investment and cash holdings.

On the investment–uncertainty relationship: A game theoretic real option approach

This paper examines the effect of uncertainty on investment timing in a game theoretic real option model. We extend the settings of the related recent literature on investment timing under uncertainty by a more general assumption, i.e. the investment is also influenced by the actions of a second player. The results show that a U-shaped investment–uncertainty relationship generally sustains even for infinite-lived investment projects and proper defined cash flows. However, timing of an investment occurs inefficiently late. Moreover, we show that the influence of uncertainty on the associated first-mover advantage becomes ambiguous, too.

Symmetric equilibrium strategies in game theoretic real option models

This paper considers the problem of investment timing under uncertainty in a duopoly framework. When both firms want to be the first investor a coordination problem arises. Here, a method is proposed to deal with this coordination problem, involving the use of symmetric mixed strategies.The method is based on Fudenberg and Tirole [Fudenberg, D., Tirole, J., 1985. Preemption and rent equalization in the adoption of new technology. Review of Economic Studies 52, 383–401], where it was designed within a deterministic framework. This paper extends the applicability of this method to a stochastic environment. The need for this is exemplified by the fact that ever more contributions in multiple firm real option models make unsatisfactory assumptions to solve the coordination problem mentioned above. Moreover, our approach allows us to show that in many cases it is incorrect to claim that, in equilibrium, the probability that both firms invest simultaneously while it is only optimal for one firm to invest, is zero.

Strategic development and growth of emerging renewable energy ventures from China

PurposeEntrepreneurial ventures in the emerging renewable energy sector in China represent a variety of dynamic growth strategies that are stimulated by the domestic energy policy and the evolution of the value chain driven by technological advancements. This paper aims to examine the underlying real options among these first movers to proceed with their further strategic development and finance means.Design/methodology/approachA literature review is launched to look into the emerging renewable energy sector unveiling challenges in the growth and development of renewable energy ventures (REVs) in China. Three main types of REVs are differentiated based on their technology intensity.FindingsThe prospect of international technology transfer through mergers and acquisitions (M&As) in the next phase of evolution within the sector is articulated. A theoretical framework on complementary developments in the value chain is revealed with four propositions.Practical implicationsThis paper enables the stakeholders in the renewable energy sector to critically reexamine the pathways of strategic development and finance of REVs over an evolving technological landscape.Originality/valueThis study integrates the theoretical real options into technology management issues pertinent to REVs under the contemporary tactics via cross‐border M&As.

Analysis of Patent Acquisition Competition between Small Company and Big Company: A Game Theoretical Real Options Approach

Analysis of Patent Acquisition Competition between Small Company and Big Company: A Game Theoretical Real Options Approach