Contrasting two approaches in real options valuation: Contingent claims versus dynamic programming

Valuing Intangible Assets Through Real Options Theory: Some Critical Remarks

PurposeThis study aims to conceive and develop a pricing model for the Ijara contingent convertible contract (ICCC, hereafter), considering the possibility that the lessee may default. The ICCC model grants the lessor the option of converting the unpaid amount into equity or recovering the leased equipment and selling it at market price in case of financial distress.Design/methodology/approachThe ICCC is consistent with the profit-sharing approach and the new risk management techniques, which are compatible with Islamic philosophy. Relying on real options theory and the contingent claim approach, a closed-form solution of the firm’s assets is developed in a dynamic environment, where the rate of return is generated by a Cox-Ingersoll-Ross stochastic process.FindingsExamining the numerical analysis reveals the impact of the firm value, the conversion or sell decision and the conversion ratio and volatility on the ICCC value. The value of the ICCC can increase substantially as the value of the firm approaches the conversion threshold. The conversion ratio as well as the asset market price play equally an important role in the decision to convert or sell.Originality/valueThis paper develops a pricing model for a contingent Ijara contract, which incorporates a conversion option to mitigate the lessee’s credit risk during periods of economic instability. The ICCC is a cooperative strategy that would be advantageous to all parties, including the lessor and lessee. In the event of a conversion, businesses may be able to continue operating thanks to this financial innovation, and the lessor may profit from the company’s recovery by freeing up more resources for the use of more profitable ventures.

Dynamic investment strategies with demand-side and cost-side risks

We consider a general model for an investment producing a single commodity, and, assuming that there exists a traded asset spanning the corresponding market, we prove a “verification theorem” which relates the solution of an appropriate differential equation with the investment's contingent claim price. In this way, we show in a mathematically rigorous way that the contingent claim approach and the dynamic programming approach to the problem of asset valuation are equivalent, modulo parameter calibration. Our analysis can be used in a straightforward way to address a big number of investment models.

Situations involving real investment options in the presence of multiple sources of jump risk, and controls are analyzed. Randomly arriving jumps include also the special cases of jump-to-ruin on the underlying asset, or on the contingent claim. Management has available impulse-type controls with random outcome. The analytic solutions when available, and a Markov-Chain numerical approach for solving more general investment decision problems are demonstrated

Метою статті було дослідження можливостей врахування ризику у процесі оцінювання вартості підприємства. Розглянуто місце оцінки ризику в процесі оцінювання вартості підприємства. Лише один із запропонованих підходів прямо визначає значення ризику та його вплив на вартість, а саме дохідний, решта підходів опосередковано зазнає впливу ризиків на вартість підприємства. Надано перелік методик визначення значення ризику в розрізі застосування дохідного підходу за рахунок встановлення ставки дисконтування. З’ясовано та подано сутність аналізу фінансового стану підприємства, основних показників, що його визначають, для подальшого застосування цих величин в аналітичній роботі. Визначено, що найкращим методом врахування ризику є метод кумулятивної побудови. Оцінювання вартості підприємства повинна враховувати всі методи, що забезпечить врахування можливих джерел виникнення ризиків.

This study attempts to obtain the optimum cut-off grade using Monte Carlo simulation assisted by real option theory. After studying the existing theories of real options, we introduce a jump diffusion real options price model to the traditional research on mineral resources price, and deduce a back - calculation formula about cut-off grade; then, produce some future prices by stochastic simulation; and then, simulate the future price changing process by using computer-assisted Monte Carlo method and indirectly obtain the optimal current cut-off grade; finally, take a mining enterprise as the detailed example to validate the results.

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.

In this study we re-examine the pricing of equity and the risk incentives of shareholders in levered firms. We derive a down-and-out call equity valuation model which rests on the assumption that shareholders choose the optimal investment and asset returns' volatility as a function of current leverage. Contrarily to the Black and Scholes framework where, irrespective of the firm's leverage, they would always select infinite volatility projects, here the more deep out-of-the-money the shareholders' claim, the greater their incentives to select riskier investment projects. The model is thus consistent with and quantifies the asset substitution problem previously acknowledged by the agency literature.

Food production decisions in Nigeria are made mainly by small-scale\nfarmers who face a number of risks. In response, farmers engage in some\nrisk management strategies which may have social and economic\nimplications not only on the farming households in particular, but the\nentire economy. This study identified the sources of risk and the\nmanagement strategies employed by the food crop farmers. A two-stage\nsampling procedure was used in the collection of primary data. The\nfirst stage involved a random selection of 30 farming communities from\nthe three agro-ecological zones of the state’s Agricultural\nDevelopment Programme (ADP) namely Ife-Ijesa, Osogbo and Iwo zones. The\nsecond stage involved a random selection of food crop farmers from each\nof the villages with probability proportionate to size of each farming\ncommunity. Data from 165 respondents were used for the analysis.\nPrimary data collected included sources of risk, other environmental\nfactors and management strategies employed. Secondary data were also\nobtained from Osun State Agricultural Development Programme (OSSADEP)\nrecords to complement the primary data. The data were analyzed using\ndescriptive statistics and composite analysis. Sources of risk in the\nlast three years were market failure, 54.5%; price fluctuation, 46.1%;\ndrought, 32.7%; pest and diseases attack, 33.9% and erratic rainfall,\n39.4%. Majority of the food crop farmers in the study area were in the\nmedium risk category. The mean value of 2.68 (approximately 3.0)\nimplies that an average food crop farmer experienced up to three\ndifferent sources of risk in the study area. Risk management strategies\navailable to the farmers were extension services, 67.3%; access to\nfertilizer, 41.2%; mixed cropping/farming, 79.3%; cooperative society\n54.5%, borrowing of money, 73.0% and off farm-work, 69.7%. Attention\nshould be shifted towards protection of farmers against market failure\nand price distortion or fluctuations as these, among others could\nimpair the growth potential of these farmers. Investment in irrigation\nprojects by the government would also save the farmers from drought and\nerratic rainfall while farmers are encouraged to benefit from the\nservices of the agricultural insurance industry.

Property developments are inherently uncertain and risky. As a result, several risk management techniques are adopted by property developers in the Australian property development sector to mitigate the impact of potential downside risks. However, uncertainty can create potential upside opportunities for property developers during the property development process which can be explored through flexibility/real options analysis. Several quantitative models and applications have been executed in the literature on flexibility/real options analysis, but practical adoption is still lacking because practitioners are yet to fully understand the theory and its potential benefits. In this paper, a conceptual model is developed to capture flexibilities/real options and linked to the property development process to determine the exact stages within the property development process where real options could be embedded to retain the potential for capturing future upside benefits from uncertainty. Through face to face semi-structured interviews with twelve different stakeholders in the Australian property development industry, thematic analysis and extensive literature review on real options theory, a conceptual model is developed. There are several flexibilities/real options naturally embedded at different stages of the property development process. Other flexibilities can be embedded in the development process deliberately by property developers with the intention of capitalising on upside opportunities in future. These flexibilities embedded at different stages of the development process has the potential to serve as a risk mitigation tool for property developers in Australian property development sector. The model can serve as a practical tool and a visual aid for property development practitioners and stakeholders to determine the exact stages in the property development process where real options are embedded and the specific types of options. It will also aid in deepening the understanding of practitioners regarding real options in property development and further enhance potential acceptance and adoption in the Australian property industry. The linkage to the property development process can enhance easy identification of flexibilities/real options at different stages of the property development process. A model that links real options to the different stages of the property development process is new in the literature.

Exploration geophysicists and geologists are familiar with the process of risk assessment and economic evaluation of oil and gas prospects. Many asset teams are required to conduct individual portfolio management exercises when competing for company resources. In the broader world of finance and economics, real options theory has developed into a sophisticated tool for evaluating and managing large investment portfolios of mixed assets with different risk characteristics. Although examples of option-based analysis have been documented in the oil and gas industry, many applications only address downstream operations. However, the influence and application of real options analysis throughout the entire E&P lifecycle has been limited. Before accepting real options as a common practice in any oil and gas company, a better understanding of this technically demanding process must be achieved. Specifically, in upstream applications of real options, explorationists require a basic understanding of the principles of real option theory before they can add this tool to their arsenal of oil and gas investment evaluation. In the competitive and dynamically changing business environment, success is often measured by management's flexibility and ability to adapt to changes. However, traditional approaches to decision-making assume a static, and rather linear, decision-making process with fixed outcomes. Valuation methods that rely on discounted cash flow (DCF) series, such as net present value (NPV), do not capture all the intrinsic attributes of an investment opportunity. Real options, as its name implies, uses the well-established rules of option theory to evaluate physical or real assets. For years the investment industry has used option theory to analyze financial assets or stocks and bonds. Only in the past decade has real options started to receive more general attention. Unlike the traditional DCF approach, real options assume a dynamic series of future decisions, which provide flexibility to adapt to given changes in …

Part of the liberalization effort in the Netherlands was to regulate the income of the network companies. Although the reduction in income was not as dramatic as in the United Kingdom, it still forced the network companies to review their expenditures. Complicating the challenge was the silent requirement that the cost reduction should not result in more risk. This required a change in the valuation methods. So far these valuation methods have changed from purely technical criteria into a more risk based, net present value alike approach. The real option theory is not commonly used in the decisions. This seems a bit odd, as major uncertainties influence the valuation process. In this paper a few options in which the real option theory might be valuable are presented. It is an invitation to the real option specialists to show the network companies how real options could be of value.

Contingent claims are traditionally priced through the use of replicating portfolios, or risk neutral valuation. When markets are incomplete, as it occurs with many projects and is often the case with claims on real assets when firms are subject to private, project specific risks, these risks cannot be hedged and a replicating portfolio cannot be built. This paper proposes a modified approach that enhances the methodology originally developed by Copeland and Antikarov (2001) which provides a practical method to evaluate projects where management flexibility and correlated risks are present, using the concept of partially complete markets by Smith and Nau (1995). Key words: real options, correlated uncertainties, private risks.

A fundamental problem in risk management is the robust aggregation of different sources of risk in a situation where little or no data are available to infer information about their dependencies. A popular approach to solving this problem is to formulate an optimization problem under which one maximizes a risk measure over all multivariate distributions that are consistent with the available data. In several special cases of such models, there exist dual problems that are easier to solve or approximate, yielding robust bounds on the aggregated risk. In this chapter, we formulate a general optimization problem, which can be seen as a doubly infinite linear programming problem, and we show that the associated dual generalizes several well-known special cases and extends to new risk management models we propose.