Optimal investment and production decisions and the value of the firm

We explore the effects of uncertainty on a firm that can respond by modifying its investment or production schedule (or both simultaneously) to variations in output price. Investment may increase capacity and/or reduce costs. We consider a firm with finite resources.Our model uses option theory instead of the more traditional net present value framework. One of the early papers using this approach is Brennan and Schwartz (1985) in which an investment project to extract a finite natural resource is valued. In that paper, the value of the firm is a function of two state variables, the finite resource to be extracted (output to be produced in the future) and the commodity spot price. In order to maximize firm value, the manager can respond by modifying one control variable, the production level. In our model we handle instead three state variables (spot price, resources, accumulated investment) and two control variables (production rate and investment rate), and solve numerically.We obtain both the value and the optimal policy of a firm that has investment projects that increase capacity and/or reduce costs and illustrate optimal policies as resources and available investments decrease over the life of the firm. Firms may start by only investing, then invest and produce, to end only producing.We thank Scott Wo, the referee and the editor for their comments and suggestions. Cortázar and Lowener acknowledge the financial support from FONDECYT and FONDER.     

Real Options: Experimental Evidence

Empirical testing of the real options theory has been very limited. This is primarily due to various inherent problems with obtaining field data for many components of real options theory. This paper utilizes experimental methodology to generate the data. The advantage of the experimental approach is that it enables the investigator to generate reliable and replicable data in a controlled environment. The results of the experiment indicate that fundamental insights of real options theory are not evident to individual investors. The majority invested too early and thus failed to recognize the benefit of the option to wait. However, when the investors had to compete with others for the right to invest, their bids generally reflected the value of the embedded option. Furthermore, as predicted by the theory, their bids increased with greater uncertainty about future cash flows from the investment.     

Real investment and risk dynamics

We ask to what extent the negative relation between investment and average stock returns is driven by risk. We show that: (i) the average return spread between low and high asset growth and investment portfolios is largely accounted for by their spread in systematic risk, as measured by the loadings on the Chen, Roll, and Ross (1986) factors; (ii) as predicted by q-theory and real options models, systematic risk falls during large investment periods; (iii) the returns of factors formed on the investment-to-assets, asset growth, and investment growth all forecast aggregate economic activities. Our evidence suggests that risk plays an important role in explaining the investment-return relation.     

High-speed rail transport valuation and conjecture shocks

In this paper, we derive the optimal investment policy in a high-speed rail transport (HSR) project. We assume that the source of uncertainty comes from the annual demand, and that it follows a geometric Brownian motion with jumps of random magnitude, occurring in random times, according to a Poisson process. We assess the impact of these shocks on the demand threshold, along with the investment opportunity value and option to differ. We consider several distributions for these jumps, and we compare with the no-jumps case. Numerical results are presented, showing the importance of assumptions about the underlying stochastic process.     

Real Options, (Dis)Investment Decision-Making and Accounting Measures of Performance

This paper suggests that a residual income-type measure of performance can be designed which supports optimal investment and disinvestment decision-making in a real options framework involving the options to wait before investing and to abandon. The measure has a number of advantages and disadvantages. Nonetheless, the balance of advantage versus disadvantage for the proposed measure must be set against the inadequacies of other competing measures of performance and associated organisational designs. Even if the measure of performance suggested is not regarded as practically useful, it has another general advantage – it can be used as a benchmark against which to evaluate other performance measures with regard to their support of optimal investment and disinvestment decision-making in a real options framework.     

Real Options, (Dis)Investment Decision-Making and Accounting Measures of Performance

This paper suggests that a residual income-type measure of performance can be designed which supports optimal investment and disinvestment decision-making in a real options framework involving the options to wait before investing and to abandon. The measure has a number of advantages and disadvantages. Nonetheless, the balance of advantage versus disadvantage for the proposed measure must be set against the inadequacies of other competing measures of performance and associated organisational designs. Even if the measure of performance suggested is not regarded as practically useful, it has another general advantage – it can be used as a benchmark against which to evaluate other performance measures with regard to their support of optimal investment and disinvestment decision-making in a real options framework.     

Optimal investment of an insurer with regime-switching and risk constraint

We investigate an optimal investment problem of an insurance company in the presence of risk constraint and regime-switching using a game theoretic approach. A dynamic risk constraint is considered where we constrain the uncertainty aversion to the ‘true’ model for financial risk at a given level. We describe the surplus of an insurance company using a general jump process, namely, a Markov-modulated random measure. The insurance company invests the surplus in a risky financial asset whose dynamics are modeled by a regime-switching geometric Brownian motion. To incorporate model uncertainty, we consider a robust approach, where a family of probability measures is cosidered and the insurance company maximizes the expected utility of terminal wealth in the ‘worst-case’ probability scenario. The optimal investment problem is then formulated as a constrained two-player, zero-sum, stochastic differential game between the insurance company and the market. Different from the other works in the literature, our technique is to transform the problem into a deterministic differential game first, in order to obtain the optimal strategy of the game problem explicitly.     

American option pricing with discrete and continuous time models: An empirical comparison

This paper considers discrete time GARCH and continuous time SV models and uses these for American option pricing. We first of all show that with a particular choice of framework the parameters of the SV models can be estimated using simple maximum likelihood techniques. We then perform a Monte Carlo study to examine their differences in terms of option pricing, and we study the convergence of the discrete time option prices to their implied continuous time values. Finally, a large scale empirical analysis using individual stock options and options on an index is performed comparing the estimated prices from discrete time models to the corresponding continuous time model prices. The results show that, while the overall differences in performance are small, for the in the money put options on individual stocks the continuous time SV models do generally perform better than the discrete time GARCH specifications.     

Binomial option pricing with stochastic parameters: A beta distribution approach

This research extends the binomial option-pricing model of Cox, Ross, and Rubinstein (1979) and Rendleman and Barter (1979) to the case where the up and down percentage changes of stock prices are stochastic. Assuming stochastic parameters in the discrete-time binomial option pricing is analogous to assuming stochastic volatility in the continuous-time option pricing. By assuming that the up and down parameters are independent random variables following beta distributions, we are able to derive a closed-form solution to this stochastic discrete-time option pricing. We also derive an upper and a lower bounds of the option price.     

Index-option pricing with stochastic volatility and the value of accurate variance forecasts

In pricing primary-market options and in making secondary markets, financial intermediaries depend on the quality of forecasts of the variance of the underlying assets. Hence, pricing of options provides the appropriate test of forecasts of asset volatility. NYSE index returns over the period of 1968–1991 suggest that pricing index options of up to 90-days maturity would be more accurate when: (1) using ARCH specifications in place of a moving average of squared returns; (2) using Hull and White's (1987) adjustment for stochastic variance in the Black and Scholes formula; (3) accounting explicitly for weekends and the slowdown of variance whenever the market is closed. (JEL C22, C53, C10, G11, G12)     

房地产市场运行及未来趋势展望

2011年在以限购为主的房地产调控政策作用下,市场需求受到抑制,商品房销售增速明显低于历史同期平均水平。保障性住房全年开工建设任务已经提前完成,受其拉动,房地产开发投资保持高位。当前,保障性住房建设全面展开,以限购为主的调控政策短期不会退出,并呈现向二三线城市扩大的趋势,一些前期房价上涨过快的城市降价促销愈演愈烈,商品房价格回调趋势明显。     

Real options with a double continuation region

If the average risk-adjusted growth rate of the project's present value V overcomes the discount rate but is dominated by the average risk-adjusted growth rate of the cost I of entering the project, a non-standard double continuation region can arise: The firm waits to invest in the project if V is insufficiently above I as well as if V is comfortably above I. Under a framework with diffusive uncertainty, we give exact characterization to the value of the option to invest, to the structure of the double continuation region, and to the subset of the primitives' values that support such a region.     

Financial Shocks and Corporate Investment in Emerging Markets

We examine how cross-firm and cross-country heterogeneity shapes the responses of corporate investment in emerging markets to changes in U.S. monetary policy and financial-market volatility, the latter proxying for uncertainty. We find that in response to increases in U.S monetary policy rates or financial-market volatility, financially weaker firms reduce investment by more than financially strong firms. We also show that firms with stronger balance sheets delay investment voluntarily when faced with higher uncertainty. Finally, we find that stronger macroeconomic fundamentals (lower public debt or higher international reserves) help to buffer corporate investment from increases in U.S. monetary policy rates.     

Company investment announcements and the market value of the firm

This paper examines the stock market reaction to 402 company investment announcements made by UK companies during the 1991–1996 period. The market-adjusted abnormal returns are generally positive but small. Investment announcements are classified according to functional categories, and we find the level of abnormal returns to vary according to the type of capital investment being announced. In particular, we find the market to react more favourably to investments that ‘create’ future investment opportunities, than to investments which can be categorized as ‘exercising’ investment opportunities. The market reaction also varies with firm size, with large companies tending to experience smaller responses to announcements than do smaller firms. Chung et al. (1998 Chung, KH, Wright, P and Charoenwong, C. (1998). Investment opportunities and market reaction to capital expenditure decisions. Journal of Banking and Finance, 22: 41–60.  ) reported that the quality of a company's investment opportunities is the primary determinant of market reactions to capital expenditure decisions. The findings presented here lend some support to a role for investment opportunities in market valuations. Project size is also found to have a significant positive impact on the level of abnormal returns.     

Corporate investment and financing under asymmetric information

We develop a dynamic model of corporate investment and financing decisions in which corporate insiders have superior information about the firm's growth prospects. We show that firms with positive private information can credibly signal their type to outside investors using the timing of corporate actions and their debt-equity mix. Using this result, we show that asymmetric information induces firms with good prospects to speed up investment, leading to a significant erosion of the option value of waiting to invest. Additionally, we demonstrate that informational asymmetries may not translate into a financing hierarchy or pecking order over securities. Finally, we generate a rich set of testable implications relating firms’ investment and financing strategies, abnormal announcement returns, and external financing costs to a number of managerial, firm, and industry characteristics.     

Stochastic duration and fast coupon bond option pricing in multi-factor models

Generalizing Cox, Ingersoll, and Ross (1979), this paper defines the stochastic duration of a bond in a general multi-factor diffusion model as the time to maturity of the zero-coupon bond with the same relative volatility as the bond. Important general properties of the stochastic duration measure are derived analytically, and the stochastic duration is studied in detail in various well-known models. It is also demonstrated by analytical arguments and numerical examples that the price of a European option on a coupon bond (and, hence, of a European swaption) can be approximated very accurately by a multiple of the price of a European option on a zero-coupon bond with a time to maturity equal to the stochastic duration of the coupon bond. This revised version was published online in June 2006 with corrections to the Cover Date.     

Real options at the interface of finance and operations: exploiting embedded supply-chain real options to gain competitiveness

Exploiting embedded supply-chain real options creates powerful opportunities for competitive manufacturing in high-cost environments. Rather than seeking competitiveness through standardization as is common to lean production, real-options reasoning explores opportunities to use supply-chain variability as a strategic weapon. We present an illustrative case study of a Swiss manufacturer of cable extrusion equipment supported by a formal real-options model that aids in valuing the embedded options that make up supply-chain flexibility: postponement, contraction, expansion, switching, and abandonment. Real-options reasoning provides a plausible retrospective rationale for the case firm's use of supply-chain flexibility that provided protection against competition from low cost, but less responsive competitors. Their intuitive real-options reasoning facilitated incorporating fuller information concerning volatility, flexibility, and control into choosing what products to make, in what quantity, and with work allocated to which supplier. The case study also highlights how competing through exploiting embedded real options requires a different managerial skill set than does competing through cost reduction. Skills such as customer communication, supplier management, and ability to ensure a smooth flow of production join the ability to reduce and control lead times as key sources of competitive advantage.     

Real Estate Investment Trusts and Stock Price Reversals

A trigger value of –5% is used to identify a sample of real estate trusts (REITS) that experience substantial one-day price declines. Abnormal returns are then calculated for the subsequent two-day period. The results of this study suggest stock price reversals are associated with extreme stock price declines for REITS. Hence, it appears the market overreacts at the time unfavorable information about REITS is disseminated. The degree of reversal across the sample is assessed according to variables such as the initial price decline (day 0), pre-event leakage (day –1), size (capitalization), the type of real estate investment trust, and relative trading volume.