Real option valuation when risks are co-integrated
Abstract
An extension of the real option valuation model to the case of co-integrated random variables was developed, using an error correction representation of randomness in output prices and input costs. Real option theory indicates that timing and risk considerations can generate value to an option on postponing an investment opportunity. This option value is the opportunity cost of investing immediately and it can be measured using financial option valuation techniques. Existing theory shows that the assumption of a nonstationary time series process for the project value affects the result. If risks are co-integrated, the expected cash flows from an investment project are stationary, consistent with long-run equilibrium. An error correction representation of the co-integrated prices and costs is used to simulate the path of expected present values. The expected percentage change parameter estimated with this procedure is time-varying and can take positive or negative signs, in contrast to the assumption of constant drift rates used in previous real options models. Applications of the procedure to investment decisions in the hog production industry were demonstrated, including analysis of the effects of risk-shifting contracts and segregated early weaning technology. Option values were lower using the co-integration procedure than using the assumption of geometric Brownian motion with no drift. This is because the mean-reverting tendency of the co-integrated series generally made the drift parameter less than zero. Uncertain prices and costs can create a positive-valued option to postpone investment in production facilities, depending on initial conditions. The value of the option was around two-thirds of sunk costs. Real option values were reduced or eliminated by risk-shifting contracts in the hog industry. Risks associated with output variation and price and costs were not sufficient to create positive-valued options to postpone adoption of early-weaning technology if long-run performance is expected to be similar to early experience. But if benefits of the technology are assumed to be transitory, then the optimal decision is to postpone investment.
Degree
Ph.D.
Advisors
Baker, Purdue University.
Subject Area
Agricultural economics|Finance
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