Types Of Real Options Research Articles

Debt and Optionality in U.S. LNG Export Projects

U.S. liquefied natural gas (LNG) export projects have substantially more spot trading of LNG than traditional projects. While this reduces the debt capacity of the projects, it allows project developers to better exploit many types of real options. Exploiting those options greatly increases the positive skewness of project cash flows. While the modal operating profits for a representative U.S. LNG export project are unlikely to cover fixed costs, interest and taxes at usual leverage ratios, the mean real equity return is likely to be positive. Some quarters could return extremely high profits. Understanding determinants of spot trading of LNG matters because increased spot trading will better integrate global natural gas markets.

РЕАЛЬНІ ОПЦІОНИ ЯК ФІНАНСОВІ ІНСТРУМЕНТИ СПРИЯННЯ ВІДБУДОВІ ПІСЛЯВОЄННОЇ ЕКОНОМІКИ УКРАЇНИ

Using the example of the Ukrelektromash plant, the application of various types of real options is considered depending on the development of the project scenario for the production and sale of rotary hybrid engines. The conditions and criteria for the application of option mechanisms are defined, taking into account the impact of risks, which is reflected in the assessment of the probabilities of the development of one or another type of scenario. The effectiveness of using abandonment and switching real options to a related type of activity in the event of a pessimistic development of cash flow and options to expand and replicating experience real option in the event of an optimistic scenario has been proven. At the same time, the degree of effectiveness of the manager's actions is shown, depending on the results of the project's cash flows after the first year of implementation. It has been established that real options are able to generally increase the strategic value of international investment projects, creating conditions for the post-war reconstruction of Ukraine's industry and encouraging the cooperation of foreign investors. In this way, the use of real options enables the manager to take effective measures to manage risks and cash flows, improving the degree of attractiveness of investment projects, and thereby opening new opportunities for cooperation with foreign partners. The implementation of programs with the use of real options becomes necessary when the investor is wary of investing in the development of the country after the end of the war, and at the same time sees great potential for the development of various sectors of the economy. Reducing the degree of riskiness of projects with the help of real options contributes to the gradual restoration of industrial capacities, the acceleration of money circulation, and the improvement of trade and financial operations on international markets.

Project portfolio valuation using real options

Subject. The article analyzes the expected effect of a portfolio of projects in the face of risk and uncertainty, when using real options. Objectives. The purpose is to offer a more objective formula to assess the expected impact of a portfolio of projects for real investment objects under risk and uncertainty, using real options, and provide recommendations for improving the portfolio efficiency. Methods. The study draws on methods of real options and evaluation of investment projects through the real option value, the cash flow discounting method, synthesis, and mathematical modeling. Results. We systematized the main types of real options and developed a formula for calculating the expected effect of project portfolio implementation. The said formula shows that considering the additional long-term costs embedded in a portfolio of real options, which are associated with the use of these real options, and, therefore, reducing the overall risk of projects and the entire portfolio, permit to improve the objectivity of such calculations. Conclusions. When analyzing real options that have real assets as underlying instruments, it is often impossible to apply the computational formulae for financial options, as they differ significantly. The systematization of the main types of real options helps expand the range of application of management solutions. The offered formula enables to improve the efficiency of project insurance under risk and uncertainty and to use additional opportunities for effective development of the company.

A real option model for geothermal heating investment decision making: Considering carbon trading and resource taxes

By considering carbon trading and resource tax, this study established a bidimensional binominal lattice of a compound real option pricing model to help investors make decisions for geothermal heating projects. Two types of real options, to defer and to abandon, are simultaneously considered. Further, a case study on the decision making for a geothermal heating project in the Xiongan New Area in China was conducted to verify the feasibility of the proposed model. The results show that 1) the investors should delay the “invest-decision” at least one year under the real option rule but that investment value would at least 0.9 times more than that by the net present value method; 2) different subsidies methods could influence the investment time and project value, and one-time subsidies may lead to larger project value but delay the investment time; 3) The project value could be increased by conducting carbon trading but could be reduced by resource tax implementation; and 4) the value of option to defer is negatively sensitive to the initial fossil fuel price, but the value of the option to abandon is positively sensitive to the volatility of carbon price.

Valuation of Water Resources Infrastructure Planning from Climate Change Adaptation Perspective using Real Option Analysis

For adaptation to the changing climate, planning of new water infrastructures should be carefully evaluated by either “robust” or “adaptive” decision making methods. For this purpose, a new economic feasibility analysis framework has been developed using real option analysis that can reflect “robust” and “adaptive” perspectives in decision making. To reflect uncertainty in climate (“robust”), the probabilities of drought occurrences are estimated by the results of dam storage simulation. To provide flexibility in decision making (“adaptive”), three different types of real options are used as a form of a decision tree. By re-evaluating economic feasibility of the Boryeong Dam conduit project, it is found that the “abort” option can be the best choice for minimal economic loss on the project. Further, more conditions for maximizing economic feasibility on the project are addressed from the sensitivity analysis. It is found that the “invest” option would be more economically feasible than “abort” option, when the probability of severe drought increases by approximately 20%. Thus, though the Boryeong Dam conduit project is not economically feasible for now, it might be an appropriate infrastructure if it is constructed in the future, when the probability of drought occurrence increases.

Real Estate Price Dynamics and the Value of Flexibility

This paper presents a model of real estate asset price dynamics based on empirical evidence, economic theory, and common sense. We note important differences between real estate versus stock market price dynamics. We then use this model to simulate the investment performance of archetypical property investments, in stabilized income-producing property, and in multi-asset development projects. We quantitatively explore the effects of uncertainty on investment performance, for example, the positive skew in the valuation distribution and the positive bias in the pro-forma return compared with the expected return due to Jensen’s Inequality. We then focus on the value added by flexibility, including various types of real options in development projects. We consider the value of resale timing flexibility in stabilized property investment, and the value of production delay and product switching options in the development project. We find that with typical real estate price dynamics, flexibility adds considerable value, and greatly improves the expected return. In stabilized property investment, resale timing flexibility can add 25% to the private valuation of the property. In multi-asset development, we find that timing options are redundant within themselves, but additive with product type options. Delay options provide significant downside protection, and combined with product switching can add over one-third to the value of the project as measured by its implied bid-price for the land.

Manager’s Flexibility & Cancellation Option: Insights of a Case Study in the Latin American Oil Industry

Purpose: This article focused on the main business insights of the use of Real Options valuation analysis in the eyes of a finance professional. It used a case study of an investment opportunity in the oil and gas field services industry in Latin America to discuss the methodology implementation and its insights. As a secondary objective, it discussed the insights and options embedded in this investment opportunity.Methodology: The investment opportunity was examined using the Real Options Analysis (ROA) framework and the results compared to the traditional methodology of Net Present Value. The valuation technique was performed as if it had been applied at the time the project was approved.Findings: The most important of Real Option valuation is not the results, but how one arrives at them. After the project value is calculated and the project approved or not, the Real Option valuation requires and supports the monitoring of the project. By understanding how the options are created, managers can make better decisions about the project after it was approved.Practical implications: A relevant contribution from the study was the discussion, as a practitioner, of the methodology implementation in a real world corporation. Originality & value: The case study evaluated two types of real options: first, the effect of an option to cancel a contract that was assessed from the perspective of the client contracting the project; and second, the option to abandon and defer, from the perspective of the company that will perform the investment to provide the services. By incorporating the cost of the put option that the company puts forth for the client (cancellation option) it reduces the project value by giving flexibility to its clients.

Valuación de la viabilidad de un cambio tecnológico en México utilizando opciones reales

This paper deals with the economic valuation of the electric energy generation system’s technological change in Mexico. Such change is aimed at reducing the pollution resulting from the electric energy generation process, and/or to optimize its operating and production costs, through the substitution of the carbo-electric energy generation system, for a nucleo-electric one, using different types of real options, namely, a technological change real option and a project expansion one. In order to calculate the term structure of risk free interest rate, the short rate model proposed by Cox, Toss and Rubinstein (1979) is used.

A real options approach to biotechnology investment policy—the case of developing a Campylobacter vaccine to poultry

The aim of the article is to identify and analyse public-private incentives for the development and marketing of new animal vaccines within a real options methodological framework, and to investigate how real options methodology can be utilized to support economic incentives for vaccine development in a cost-effective way. The development of a vaccine against Campylobacter jejuni in poultry is applied as a case study. Employing the real options methodology, the net present value of the vaccine R&D project becomes larger than a purely probabilistic expected present value throughout the different stages of the project − and the net present value becomes larger, when more types of real options are taken into consideration. The insight from the real options analysis reveals opportunities for new policies to promote the development of animal vaccines. One such approach might be to develop schemes combining stage-by-stage optimized subsidies in the individual development stages, with proper account taken of investors’/developers' economic incentives to proceed, sell or cancel the project in the respective stages. Another way of using the real options approach to support the development of desirable animal vaccines could be to issue put options for the vaccine candidate, enabling vaccine developers to hedge against the economic risk from market volatility.

Issues in real options with shadow costs of incomplete information and short sales

This paper presents the valuation of real options and the capital budgeting models within shadow costs of incomplete Information and short sales. Shadow costs are sunk costs in the spirit of Merton's (1987) model of capital market equilibrium with incomplete information.The shadow cost includes two components. The first component is the product of pure information cost due to imperfect knowledge and heterogeneous expectations. The second component represents the additional cost caused by the short-selling constraint. Information costs are linked to Merton's (1987) model of capital market equilibrium with incomplete information, CAPMI. This model is extended by Wu, Li and Wei (1996) who propose an incomplete-information capital market equilibrium with heterogeneous expectations and short sale restrictions, GCAPM. This model is used in our paper to provide for the first time in the literature analytic solutions for derivatives in the presence of both shadow costs of incomplete information and short sales.Shadow costs are used in standard discounted cash flow techniques and real options. The justification of shadow costs in real projects is based on the observation that R&D needs to be done before investment decisions. The main results regarding real options and shadow costs of incomplete information and short sales are proposed by extending the analysis in Bellalah (1999, 2000) and Bellalah and Wu (2009).Our results have important implications in terms of pricing derivative assets and different types of real options. In particular, this framework can be easily implemented in investment decisions and the valuation of flexibility embedded in real projects. In fact, several investment decisions under uncertainty can be reformulated and their results can be implemented in the presence of incomplete information and investment constraints.

Метод реальных опционов в оценке инвестиций в горнодобывающей отрасли

Investment in mining projects involves significant costs, long period of time, consistent type of investment decisions and complex mosaic of the many unforeseen factors affecting the cost of the project. Real options valuation (ROV) is one of the modern methods of assessment that helps in adaptation and revision of mining projects under uncertainty. Application of the method is technically demanding and requires a certain knowledge of the mining industry, and also has three main barriers: the problem of marketing, analysis and consequences. The mathematical basis of this method is a valuation model based on option pricing model, invented by Black — Scholes. List of alternatives and opportunities in project phases discussed in the article demonstrates perfect suitability of the mining industry for practicing different types of real options.

Real options valuation of international railway construction projects: a case study

This paper aims to analyse an actual complex, real-life international railway construction project by using real option approach (ROA), namely, the Mecca Railway Construction Project conducted by the China Railway Construction Corporation Limited (CRCC) in 2009, in which the company had made a huge financial loss. This research tries to retrieve the company’s decision process by calculating the net present value (NPV) of the project, and further evaluate the real options embedded in the project by using binomial tree method and Black-Scholes option pricing model. The employed methods help to have evaluated two types of real options in the project, i.e., option to abandon and option to defer. We have shown that the embedded options in the project contract could have reduced the company’s financial loss by adopting flexible strategies in decision-making.

A Cruise Line Dynamic Overbooking Model with Multiple Cabin Types from the View of Real Options

The fundamental booking decision for a cruise line involves how many reservations to accept to avoid two outcomes—either sailing with empty cabins or denying some customers’ bookings. Cruise lines accept reservations that overbook a cruise because they anticipate a number of cancellations and no-shows. The question is how many overbooked reservations to accept such that no one is denied boarding. This article applies a real options approach to formulate a risk decision model for cruise line dynamic overbooking. The analysis includes multiple cabin types and allows upgrading to reduce and avoid the two reservation risks. This article illustrates the way to find the best overbooking level vector. The analysis models a series of real options contained in the joint overbooking decision. Furthermore, the dynamic joint overbooking decision is analyzed and discussed from the view of various types of real options. Finally, numerical examples are used to demonstrate how to solve the joint overbooking problem with two given decision schemes using the real options analysis (ROA) in real-time.

Real Options in Acquisitions: Effects of Option Type and Competition on Premiums

This paper considers the differences in premiums paid between different types of real options that exist in acquisitions. We compare single and compound options by considering single acquirers versus serial acquirers and find that the first group pays lower premiums for their acquisitions. This finding is in line with real option theory stating compound options are more valuable than single options as they incorporate the value of future growth options. Next, we focus on the difference between shared and proprietary nature of options in both single and compound options. In line with real option theory predictions, we find that shared options (measured by the number of bidders) require higher premiums, while proprietary options (measured by the presence of a minority stake) result in lower premiums paid for both single and compound acquisition options. The results are robust when considering serial acquirers who focus on related targets, an acquisition strategy called “buy-and-build”. We further find that acquirer market share increases the proprietary nature of acquisition options and leads to lower premiums paid.

A Logical Approach to Real Options Identification With Application to UAV Systems

Complex systems are subject to uncertainties that may lead to suboptimal performance or even catastrophic failure if unmanaged. Uncertainties may be managed through real options that provide a decision maker with the right, but not the obligation, to exercise actions in the future. While real options analysis has traditionally been used to quantify the value of such flexibility, this paper is motivated by the need for a structured approach to identify where real options are or can be embedded for uncertainty management. We introduce a logical model-based approach to identification of real option mechanisms and types, where the mechanism is the enabler of the option, while the type refers to the flexibility provided by the option. First, we extend the classical design structure matrix and the more general multiple-domain matrix (MDM), commonly used in modeling and analyzing interdependencies in complex socio-technical systems, to the more expressive Logical-MDM that supports the representation of flexibility. Second, we show that, in addition to flexibility, two new properties, namely, optionability and realizability, are relevant to the identification of real options. We use the Logical-MDM to estimate flexibility, optionability, and realizability metrics. Finally, we introduce the Real Options Identification (ROI) method based on these metrics, where the identified options are valued using standard real options valuation methods to support decision making under uncertainty. The expressivity of the logic combined with the structure of the dependency model allows the effective representation and identification of mechanisms and types of real options across multiple domains and lifecycle phases of a system. We demonstrate this approach through a series of unmanned air vehicle scenarios.

The Smith Company: a case on capital budgeting and real options

PurposeThis paper aims to provide upper‐level accounting and/or finance students with a review of the intricacies of option pricing, discounted cash flow (DCF) capital budgeting decision models, various types of real options, how risk analysis of long‐term capital investments can be facilitated by explicit consideration of real options, and the role of sensitivity analysis in the analysis of capital investment projects with real options.Design/methodology/approachThe paper describes a fictional company facing a risky capital investment proposal. Students evaluate the investment proposal using traditional DCF analysis (i.e. the net present value method), and then re‐run the analysis by incorporating the existence of real options into the analysis of the proposed investment. Finally, students see the value of using Crystal Ball software for conducting sensitivity analysis as part of the decision‐making process.FindingsThere are two primary conceptual lessons that students realize by completing this educational case: real‐options analysis is a conceptually correct and robust way to explicitly deal with project uncertainty, and failure to explicitly consider real options in the analysis of capital investment projects may result in suboptimal decision making.Originality/valueThis case covers all major real‐option topics required for the certified management accountant exam. Further, the case fills a void in the literature of accounting education as this literature pertains to the availability of case material regarding the use of real options as an extension to conventional capital budgeting techniques.

A Risk Decision Model of Cruise Line Overbooking System with Multiple Price Classes from the View of Real Options*

As to the problem of reducing and avoiding two kinds of risks of cruise line overbooking, this paper employs the real options approach to construct a cruise line overbooking risk decision model with multiple price classes, incremental cost and nonlinear goodwill loss. We give the steps to gain the best overbooking amount, find the real options connotative in the decision, explain the computing method of the real options included in the decision, and show that the overbooking decision can be regarded as different types of real options. Finally, a numerical example shows the effectiveness and meaning of the decision model.

Interaction between technology and extraction scaling real options in natural gas production

This article is the outcome of a research engagement studying questions of technology utilization and production management with managers at EQT Corp., an integrated natural gas production and distribution company. The question of how to best leverage the use of technology is fundamental to almost any industry; this is especially true for those companies operating in the volatile field of commodities production, as does EQT Corp¨ This article considers the interaction between two types of real options that arise in natural gas production: The option to scale the production level, through enhanced extraction and communication technologies, and the option to scale the extraction rate, by pausing production. This interaction is studied by applying stochastic dynamic programming to actual operational and financial data. The analysis brings to light data-driven managerial principles pertaining to the valuation and deployment of these three scaling options, the effect of price uncertainty on the option values, how to effectively simplify the optimal deployment policy, and whether these options, or subsets of them, are complements or substitutes. These principles are significant to natural gas production managers and, potentially, to managers of other natural resource production processes, such as the extraction of oil and mining.

The Bounded Rationality Bias in Managerial Valuation of Real Options: Theory and Evidence from IT Projects*

ABSTRACTAlthough real options theory normatively suggests that managers should associate real options with project value, little field research has been conducted to test whether they suffer from systematic biases in doing so. We draw on the notion of bounded rationality in managerial decision making to explore this understudied phenomenon. Using data collected from managers in 88 firms, we show that managers exhibit what we label the bounded rationality bias in their assessments: They associate real options with value only when a project's easily quantifiable benefits are low, but fail to do so when they are high. The study also contributes the first set of empirical measures for all six types of real options. The study contributes to managerial practice by identifying the conditions under which managers must be vigilant about inadvertently neglecting real options and by providing a simple approach for assessing real options in technology development projects.

Crafting R&D Project Portfolios

OVERVIEW:Uncertain, but promising, R&D projects should be treated as one of three types of real options, depending on their degree of technical and market uncertainty. Positioning options are designed to preserve a company's future right to compete in a highly uncertain technological arena. Scouting options are used to create information about customer needs and market conditions. Stepping-stone options provide a technological path forward for an organization's long-run technology strategy, while containing cost and risk as new knowledge is created. Corporations rarely distinguish between such options and product launches or line extensions, with the result that they are managed and valued inappropriately. The guidelines provided here can not only help determine the right category for individual R&D projects, but also enable designing a portfolio of projects that is consistent with a firm's technology strategy.