Making sense of future uncertainties using real options and scenario planning

Healthcare across the world is facing many uncertainties. In Dutch healthcare, a recent policy change is forcing health organizations to deal more efficiently with their real estate, and this increases the need for real estate strategies that are more flexible. In order to support managers in incorporating flexibility in their decision-making over the design of new healthcare facilities, we have developed a method that combines scenario planning and real options. Scenario planning enhances sensemaking over the consequences of future uncertainties, and real options should help in addressing flexibility in decision-making through weighing the pros and cons of flexibility measures. We illustrate the sensemaking process by applying the method to a hospital, to a forensic clinic and to a care organization for vulnerable citizens. Data collection took place through interviews and workshops. We found that the identity and characteristics of the workshop participants influenced the sensemaking process. The method proved a useful means of making sense of abstract uncertainties that influence an organization, aspects that are normally outside the scope of real estate managers. The real options approach offered a more structured way of balancing the costs and benefits of strategies in dealing with future uncertainties.     

A real options approach for evaluating the implementation of a risk-sensitive capital rule in banks

I evaluate a bank's incentives to implement a risk-sensitive regulatory capital rule. The decision making is analyzed within a real options framework where optimal policies are derived in terms of threshold levels of credit risk. I provide a numerical example for the implementation of internal ratings based models for credit risk (the IRB approach) under the new Basel Accord (Basel II).     

An empirical study of the impact of corporate taxation on the global allocation of foreign direct investment: a broad tax attractiveness index approach

The question of whether a country’s corporate tax regime has a significant influence on the level of foreign direct investment (FDI) into that country is an important consideration in the design of national tax policy. This is especially relevant today in view of the recent increase in the global mobility of capital and subsequent increase in the importance of FDI to nations’ economies. Although several prior quantitative studies have investigated the link between taxation and FDI, they have tended to be restricted in geographical scope and in their measure of taxation.This study constructs indices of “corporate tax attractiveness” for selected countries and then analyses the relationship between the indices and measures of the flow of FDI into those countries. The indices are constructed by obtaining evaluations from international investors and taxation experts on the various attributes of the tax systems of those selected countries. A significant positive relationship was found to exist between the indices and measures of FDI inflows, and between individual tax system attributes and those inflows, thus adding support to the supposition that host country corporate taxation influences the size of FDI inflows.     

Binomial basis for linear information dynamics: real options, dividends and the valuation of equity

Analytical research has confirmed that real options give rise to the kind of nonlinearities observed in practice between equity prices and the figures appearing on corporate financial statements. We develop these real option values in terms of a quasi 'supply-side' model of linear information dynamics based on simple discrete time binomial filtration processes. Our analysis shows that the linear models that pervade the empirical (and analytical) work of the area, will almost certainly suffer from an omitted variables problem. Parameter estimation will then be inconsistent and inefficient.     

Organisational change and performance in long-lived small firms: a real options approach

This paper supports two key principles of real options reasoning: (a) the value of waiting and (b) the value of staging. It tests whether real options logic applies to small firms implementing significant changes (e.g. in technology) in a model of small firm performance, estimated on data collected by interviews with entrepreneurs. We found that to achieve a higher value by waiting, a delicate balance of precipitators of change against time until exercise is necessary (e.g. if there were just one or two precipitators, then waiting would certainly raise the value). Similarly, to achieve a higher value by staging, the entrepreneur needs to balance embedding against investment time. Thus, provided that investment time is less than 1¼ years, we found that embedding will raise the value. Overall, this implies that strategic flexibility in investment decisions is necessary for good long-run performance of small firms.     

The commodity super price cycle and real options: Implications for the Greeks of mining firms

The Real Options Approach (ROA) to the management and valuation of mining firms should impart a distinctive pattern to the time path of the Greeks displayed by such firms during the recent price super cycle. This paper simulates the delta, gamma, vega and rho of a gold mining firm holding a portfolio of heterogeneous mines over the recent gold price cycle, to find out the telltale signs that the ROA should leave on the trajectories exhibited by such variables during that period. We show that the ROA and the standard NPV approach to mine management and valuation predict markedly different trajectories for the Greeks.     

Market switching in shipping — A real option model applied to the valuation of combination carriers

This paper derives a real options model of flexibility and applies it to shipping, valuing the option to switch between the dry bulk market and wet bulk market for a combination carrier, a ship type that is capable of operating in both markets but that has fallen out of favor due to high price tags. The model is a mean-reverting (Ornstein–Uhlenbeck) version of a standard entry–exit model with stochastic prices. A closed form solution for the value of flexibility is derived, expressed in terms of Kummer functions. The estimated value of flexibility is related to historical price differentials between combination carriers and oil tankers of comparable size. Based on numerical experiments it is concluded that new combination carriers may enter the market in the near future.     

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.     

Equity value,implied cost of equity and shareholders’ real options

This study investigates the effects of shareholders’ real options on (i) firm financial performance and (ii) estimations of the implied cost of equity. After measuring the equity value of steady‐state operations using the residual income model, and the abandonment and expansion options using the Black‐Scholes option pricing model, I find that firms with a large expansion (abandonment) option value experience better (worse) financial performance than those with a small such value. I also find that ignoring these options results in a downward bias in implied cost of equity estimates by an average of 1.23 percentage points.     

Pillar 2: tax competition in low-income countries and substance-based income exclusion

Pillar 2 of the OECD's global tax reform proposal will have significant direct and indirect impacts for low-income developing countries (LICs). Most interesting and problematic is the question as to how the global anti-base erosion (GloBE) rules for a proposed global minimum effective tax will affect tax competition behaviour in LICs, and how LICs should respond when a critical mass of higher-income economies adopt the new structure. Most LICs are source-only countries, and they are very much in competition to attract foreign direct investment. Do LICs want to continue to compete using the tax system to the extent possible, to step back from that competition, or to take some intermediate course? Pillar 2 does not itself change a country's desired position on the competition spectrum – it merely affects how, and to what extent, that position can still be obtained. This paper posits that LICs should adopt qualified domestic minimum top-up taxes, and that this will not itself have a negative impact on their competitiveness. The primary focus of the paper, however, is on the design of the substance-based income exclusion (carve-out), examining the following three questions. Should the GloBE have been designed without a carve-out? Would there have been a better way of designing it? How will LICs be affected? The paper concludes that, as little real advantage is likely to accrue to LICs from intangible assets, minimising tax competition for those assets will have relatively little impact on them; and that, from an economic efficiency standpoint, shifting the tax burden away from a normal return and toward economic rents – albeit imperfectly – is a reasonable solution.     

Real (adaptation) options and the valuation of equity: some empirical evidence

Data from 1,374 firms across four broad industrial groupings are used to assess the contribution that real (adaptation) options make to overall equity values. The analysis indicates that real (adaptation) options make a significant contribution to the equity value of firms with a market to book ratio (of equity) of around unity or less. As the market to book ratio grows beyond this level, however, the contribution made by real (adaptation) options decays quickly away and equity values are mainly comprised of the present value of the dividends that firms are expected to pay. This means that for around one in every five of the firms in our sample real (adaptation) options make a significant contribution to overall equity value. Thus, while linear equity valuation models would seem to be appropriate for the substantial majority of firms on which our sample is based, there is a sizeable minority of firms where real (adaptation) options have a significant impact on equity values. For this latter group of firms there will be a non-linear relationship between equity value and its determining variables. This has important implications for the regression procedures that are applied in this area of accounting research.     

Lookback options and diffusion hitting times: A spectral expansion approach

Lookback options have payoffs dependent on the maximum and/or minimum of the underlying price attained during the options lifetime. Based on the relationship between diffusion maximum and minimum and hitting times and the spectral decomposition of diffusion hitting times, this paper gives an analytical characterization of lookback option prices in terms of spectral expansions. In particular, analytical solutions for lookback options under the constant elasticity of variance (CEV) diffusion are obtained.Received: 1 October 2003, Mathematics Subject Classification: 60J35, 60J60, 60G70JEL Classification: G13The author thanks Phelim Boyle for bringing the problem of pricing lookback options under the CEV process to his attention and for useful discussions and Viatcheslav Gorovoi for computational assistance. This research was supported by the U.S. National Science Foundation under grants DMI-0200429 and DMS-0223354.     

A dynamic programming approach for pricing CDS and CDS options

We propose a flexible framework for pricing single-name knock-out credit derivatives. Examples include Credit Default Swaps (CDSs) and European, American and Bermudan CDS options. The default of the underlying reference entity is modelled within a doubly stochastic framework where the default intensity follows a CIR++ process. We estimate the model parameters through a combination of a cross sectional calibration-based method and a historical estimation approach. We propose a numerical procedure based on dynamic programming and a piecewise linear approximation to price American-style knock-out credit options. Our numerical investigation shows consistency, convergence and efficiency. We find that American-style CDS options can complete the credit derivatives market by allowing the investor to focus on spread movements rather than on the default event.     

The role of tax regulation and compensation contracts in the decision to voluntarily expense employee stock options

We show that firms with executive bonuses that qualify for deduction under Internal Revenue Code Section 162(m) were less likely to expense stock option compensation (SOC) in 2002. Additionally, the more likely it is that a qualified firm will incur re-contracting costs, the less likely it is that the firm will expense SOC. CEOs of qualified firms that also expense SOC receive smaller bonuses than CEOs of expensing firms that are not qualified under 162(m), and the lower 162(m) bonuses are not offset by higher SOC. Our results suggest that 162(m) tax incentives are an important determinant of the decision to expense SOC.     

Product market competition and earnings management: Evidence from discretionary accruals and real activity manipulation

We examine the association between product market competition and earnings management activities. We use the Herfindahl-Hirschman Index (HHI), a widely used measure for market concentration, as a proxy for product market competition. We examine two forms of earnings management: accrual-based and real activity-based. Our results are mixed, but generally suggest that both income-increasing accrual manipulation and real activity-based manipulation are more prevalent among firms in low competition industries than those in high competition industries. Our findings are robust to various measures of earnings management, alternative measures of product market competitions, and different subsamples. We further explore the reasons why firms in low competition industries are more inclined to manage earnings and find that the market consequences of missing important earnings targets are more severe among firms in low competition industries than those in high competition industries.     

Nonlinear trends in real exchange rates: A panel unit root test approach

We analyze the possibility of nonlinear trend stationarity as the alternative to unit roots in 23 OECD real exchange rates, 1974–1998, by adding nonlinear time terms to the CIPS panel unit root test of Pesaran (2007). We follow a thorough bootstrapping approach and propose a technique to adjust statistical significance for the use of multiple tests over several time trend orders. The unit root null that all real exchange rates have unit roots is rejected at better than the 0.05 level. Bootstrapped results from a procedure of Chortareas and Kapetanios (2009) suggest that the hypothesis that all are stationary is reasonable. We argue that nonlinear trend stationarity is the most likely alternative hypothesis for at least some of the real exchange rates because: (1) the strongest CIPS rejection occurs when quadratic trends are specified; (2) nonlinear time terms are statistically significant at the 0.10 level; (3) the actual CIPS statistics are more consistent with CIPS sampling distributions from bootstrapped nonlinear trend stationary processes than from linear trend or mean stationary processes.     

Effects of uncertainty and risk aversion on the exposure of investment-style factor returns to real activity

How do uncertainty and risk aversion affect the behavior of investment-style factors? We argue that a significant channel through which both uncertainty and risk aversion impact aggregate risk factors is the exposure of factor returns to real activity. We analyze this issue using mixed data sampling decomposition of the sensitivity of factor returns to real activity into high- and low-frequency components. We find a positive and significant relation between uncertainty and risk aversion for the low-frequency component of the sensitivity of factor returns to economic activity. More importantly, risk aversion significantly amplifies the effects of uncertainty on real activity exposure. The quality-based factor is an important exception to these findings.     

Information,uncertainty, and behavioral effects: Evidence from abnormal returns around real estate investment trust earnings announcements

In this study, we examine the influence of real estate market sentiment, market-level uncertainty, and REIT-level uncertainty on cumulative abnormal earnings announcement returns over the 1995–2009 time period. We first document the relative coverage of analysts' earnings forecasts on U.S. REITs, as well as REITs from several countries (i.e., Australia, Belgium, Canada, France, Hong Kong, Japan, the Netherlands, and UK). We show that coverage outside of the U.S. is limited, and we consequently focus our analysis on U.S. REITs. We find strong evidence that earnings announcements contain pricing relevant information, with positive (negative) earnings surprises relative to analysts' forecasts resulting in significantly positive (negative) abnormal returns around the announcement date. Consistent with the findings from the broader equity market literature, we find limited evidence of a pre-announcement drift in the cumulative abnormal returns. However, in sharp contrast to the existing equity literature, we find no evidence of a post-earnings announcement drift in our aggregate sample or when the sample is restricted to the largest negative surprises. We find evidence of a post-earnings announcement drift for only the largest positive earnings surprises. These results are consistent with REIT returns more quickly impounding information relative to the broader equity market, in part because of the parallel private real estate market and because of the U.S. REIT structure and information environment. Finally, in our conditional regression analysis of cumulative abnormal returns, we find that real estate investor sentiment, market-wide uncertainty, and firm-level uncertainty significantly affect the magnitude of abnormal announcement returns and also influence the effect of unexpected earnings on abnormal returns.