Real Options in Capital Investment: Models, Strategies, and Applications

By Lenos Trigeorgis | Go to book overview

could price the options very accurately, often within 0.1 percent from standard option pricing.15 The negative exponential, the quadratic, and the power functions performed quite well, with the logarithmic utility function resulting in the largest deviation.

Sensitivity analysis results in the case of the (CPRA) power utility function relative to standard option pricing are shown in Table 3.2. The results appear robust with respect to beta (p1) and stock skewness, but are somewhat sensitive to the option's exercise price (EX) relative to the (given) underlying stock price and to the riskless interest rate. The above sensitivity analysis of the intuitively appealing power utility function did not reveal any disturbing anomalies. The results for other utility functions are similar. In general, these option valuation results verify that if the aggregate market utility function is calibrated to be consistent with the market and the stock lotteries, it will also work reliably with derivative securities.

The overall results confirm that the idea of first estimating the aggregate market utility function from the market lottery consistent with market data and then using it to price other assets seems promising. The various candidate market utility functions from the LRT class, when calibrated with the market and stock lotteries, produced quite accurate and consistent option prices as compared to standard risk-neutral valuation. These simulation results did not altogether remove any of the above-mentioned LRT candidate utility functions, as the valuations were basically consistent and close to each other. These results can provide some reassurance to those interested in empirically estimating an aggregate market utility function.


3.6 SUMMARY AND CONCLUSION

This chapter was an attempt to merge the paradigms of finance theory and decision analysis as applied to investment valuation. The two approaches generally differ in focus (e.g., what value or value to whom) and information used, which may result in different answers. We saw that the real issue is not whether finance-theoretic valuation (e.g., utilizing expected returns and betas) is better or worse than decision-theoretic valuation (utilizing a decision maker's utilities), but rather whether we should be interested in determining the subjective reservation price of some decision maker or the market price. Of course, if one is interested in some subjective value to the corporation's top management, then traditional decision analysis (using subjective probability estimates and corporate utilities) would be appropriate generally, and this subjective value would be given by the corporate break-even (selling or buying) reservation price, which generally depends on initial wealth. Finance, however, is typically interested in the market (rather than a subjective or private) value of an asset to a publically traded

-65-

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Real Options in Capital Investment: Models, Strategies, and Applications
Table of contents

Table of contents

  • Title Page iii
  • Contents v
  • Tables and Figures ix
  • Preface xiii
  • Chapter 1 Real Options: An Overview 1
  • Introduction 1
  • Acknowledgments 28
  • Notes 28
  • Part I Real Options and Alternative Valuation Paradigms 29
  • Chapter 2 Methods for Evaluating Capital Investment Decisions Under Uncertainty 31
  • Introduction 31
  • Conclusion 44
  • Notes 45
  • Chapter 3 Merging Finance Theory and Decision Analysis 47
  • Introduction 47
  • Summary and Conclusion 65
  • Acknowledgments 66
  • Notes 66
  • Chapter 4 The Strategic Capital Budgeting Process: A Review of Theories and Practice 69
  • Introduction 69
  • Conclusions 84
  • Acknowledgments 86
  • Notes 86
  • Part II General Exchange or Switching Options and Options Interdependencies 87
  • Chapter 5 The Value of Flexibility: A General Model of Real Options 89
  • Introduction 89
  • Concluding Remarks 105
  • Acknowledgments 105
  • Notes 106
  • Chapter 6 The Valuation of American Exchange Options with Application to Real Options 109
  • Introduction 109
  • Conclusion 119
  • Acknowledgments 120
  • Notes 120
  • Chapter 7 Operating Flexibilities in Capital Budgeting: Substitutability and Complementarity in Real Options 121
  • Introduction 121
  • Conclusion 130
  • Acknowledgments 131
  • Notes 131
  • Part III Strategy, Infrastructure, and Foreign Investment Options 133
  • Chapter 8 The Value of Options in Strategic Acquisitions 135
  • Introduction 135
  • Implications and Conclusions 147
  • Acknowledgments 148
  • Notes 148
  • Chapter 9 Corporate Governance, Long-term Investment Orientation, and Real Options in Japan 151
  • Introduction 151
  • Implications and Conclusions 158
  • Notes 160
  • Chapter 10 Volatile Exchange Rates and the Multinational Firm: Entry, Exit, and Capacity Options 163
  • Introduction 163
  • Conclusions 178
  • Acknowledgments 180
  • Notes 180
  • Part IV Mean Reversion/ Alternative Formulations in Natural Resources, Shipping, and Start - Up Ventures 183
  • Chapter 11 The Effects of Reversion on Commodity Projects of Different Length 185
  • Introduction 185
  • Conclusions and Extensions 199
  • Appendix 201
  • Acknowledgments 204
  • Notes 204
  • Chapter 12 Contingent Claims Evaluation of Mean-Reverting Cash Flows in Shipping 207
  • Introduction 207
  • Conclusions 216
  • Appendix 217
  • Acknowledgments 218
  • Notes 218
  • Chapter 13 Valuing Start-Up Venture Growth Options 221
  • Introduction 221
  • Conclusion 236
  • Appendix 237
  • Acknowledgments 238
  • Notes 238
  • Part V Other Applications: Pollution Compliance, Land Development, Flexible Manufacturing, and Financial Default 241
  • Chapter 14 Investment in Pollution Compliance Options: The Case of Georgia Power 243
  • Introduction 243
  • Notes 262
  • Chapter 15 Optimal Land Development 265
  • Introduction 265
  • Conclusions and Extensions 277
  • Appendix 278
  • Acknowledgments 279
  • Notes 279
  • Chapter 16 Multiproduct Manufacturing with Stochastic Input Prices and Output Yield Uncertainty 281
  • Introduction 281
  • Conclusion 298
  • Appendix 300
  • Notes 301
  • Chapter 17 Default Risk in the Contingent Claims Model of Debt 303
  • Introduction 303
  • Conclusions and Extensions 317
  • Acknowledgments 318
  • Notes 319
  • Bibliography 323
  • Author Index 347
  • Subject Index 351
  • About the Editor and Contributors 357
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