Investment under multiple risks and strategic competition : essays in real options

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Investment and Abandonment under Economic and Implementation Uncertainty

this paper was published under the title "Investment Under Economic and Implementation Uncertainty" in the April 2001 edition of R&D Management, vol. 31, no. 2, pp. 127--135. I am grateful to Dean Paxson and an anonymous referee for their invaluable comments. Usual disclaimers appl

The effect of mean reversion on entry and exit decisions under uncertainty

Many economic variables of interest exhibit a tendency to revert to predictable long-run levels. However, mean reverting processes are rarely used in investment models in the literature. In most models, geometric Brownian motion processes are used for tractability. In this paper, a firm's entry and exit decisions when the output equilibrium price follows an exogenous mean reverting process are examined, and then compared to the decisions of the firm under the usually employed assumption of lognormally distributed output price, presented in Dixit (1989a). By extending previous work by Sarkar (2003) to account for costly reversibility, we show that mean reversion has a significant effect, not only on firm-specific entry and exit decisions, but also on the balance of entering and exiting firms in an industry/market. Thus it would be erroneous to use the more tractable geometric Brownian motion process as an approximation for a mean-reverting process in models and investigations of aggregate industry investment.Investment Uncertainty Real options Mean reversion

Predictable dynamics in implied volatility surfaces from OTC currency options

Recent empirical studies report predictable dynamics in the volatility surfaces that are implied by observed index option prices, such as those prescribed by general equilibrium models. Using an extensive data set from the over-the-counter options market, we document similar predictability in the factors that capture the daily variation of surfaces implied by options on 25 different foreign exchange rates. We proceed to demonstrate that simple vector autoregressive specifications for the factors can help produce accurate out-of-sample forecasts of the systematic component of the surface at short horizons. Profitable delta-hedged positions can be set up based on these forecasts; however, profits disappear when typical transaction costs are taken into account and when trading rules on wide segments of the surface are sought.Implied volatility surfaces Static factor model Forecasting

Real Options in Operations Research: A Review

The Real Options approach to decision-making has been useful in capturing and valuing the flexibility inherent in many operating decisions that decision makers are faced with. In Operations Research (OR), a field that encompasses a plethora of problem-solving techniques for improving decision-making, we note an observable steady increase in contributions that apply the Real Options approach to model, analyze and evaluate flexible operating alternatives available to decision-makers or to optimize the operational efficiency of decision timing. We review 164 papers that appeared in five internationally-renowned OR journals in the last twelve years, cataloguing the main subject themes and contributions where the Real Options approach has been most valuable to Operations Research. We classify the reviewed papers into six main subject themes, and identify their main characteristics, the modeling approaches used, key issues and sub-categories. We further document current trends and suggest promising opportunities for future research

Enhancement in a firm's information environment via options trading and the efficiency of corporate investment

We examine the association between enhancement in a firm's information environment via options trading and firm investment efficiency. Investment inefficiency is partly driven by information asymmetries between firm managers and capital providers, aggravating moral hazard concerns. We test whether enhancement in a firm's information environment through higher volumes of options trading (including a natural experiment involving exogenous shocks via the Penny Pilot Program) is positively related to more efficient firm investment decisions. Our results confirm that enhanced informational efficiency via higher volumes of options trading is positively related to improvements in firm-level investment efficiency. Our findings are in line with the enhancement in the information environment stemming from options trading reducing agency and moral hazard concerns (an agency channel) and are not driven by alternative explanations such as managerial learning from informed traders or a lower cost of capital. Overall, our findings suggest that an enhanced information environment via more options trading benefits firms’ investment decisions