Economics 659: Real Options and Investment Under Uncertainty Course Outline, Winter 2012

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1 Economics 659: Real Options and Investment Under Uncertainty Course Outline, Winter 2012 Professor: Margaret Insley Office: HH216 (Ext ). E mail: minsley@uwaterloo.ca Office Hours: TBA Class time and location: T/Th, 2:30 3:50 pm, RCH 105 Class Number: 7902 COURSE DESCRIPTION This course considers the application of option concepts from finance to valuing real assets and investment opportunities. The focus is on using real options theory and methodology to value investments characterized by uncertainty, irreversibility, and flexibility in the timing of irreversible expenditures. We consider the implications of real options theory for the firm s decision to invest, as well as for industry equilibrium. The course begins with an introduction to stochastic processes, Ito's Lemma, the Black Scholes equation, contingent claims analysis and dynamic programming. Numerical methods to solve simple option value problems will be presented, such as binomial trees and Monte Carlo simulation. Applications will focus on problems in natural resource and environmental economics, such as valuing the option to drill for oil or install pollution control equipment and, time permitting, other applications in economics. BACKGROUND REQUIRED Knowledge of microeconomic theory, basic calculus and linear algebra and some experience with differential equations are required. Assignments require some programming in Matlab, which students are expected to learn on their own. EVALUATION There are two different grade weighting schemes shown in the table below. PhD students will be graded according to Option 2. Option 1 will be applied to MA students unless a student requests otherwise. If an MA student would prefer to be assessed according to Option 2, he/she must let me know in writing (i.e. via ) by November 8. Econ 659, Fall 2012, Course Outline Page 1

2 Weighting in final grade Due date Option 1 Option 2 (required for PhD Students) Assignment Tues Oct 9 7% 7% 1 Midterm 20% 20% Tues Oct 30 Assignment Tues Nov 20 8% 8% 2 Project Paper choice due: Thurs Oct 11; 20% 30% Write up due: Mon Dec 3 Final exam 45% 35% TBA Project: The goal of the project is for students to read and evaluate some journal articles which apply real options theory and methodology, and to summarize the article(s) in a class presentation. Option 1: Students will choose a paper from a list provided early in the term. Each student will present a summary and analysis of their chosen paper to the class. A written report (approximately 10 pages, double spaced) discussing the paper will be handed in by the deadline specified above Option 2: Students will choose several related papers in the real options literature, and compare and contrast them. The written report will be approximately 20 pages long. Paper selections must be approved by the instructor by November 1. The project will be marked out of 50, with 30 for the written discussion, 15 marks awarded for the presentation, and 5 marks for questions asked during class presentations of your classmates. (You will be responsible for asking questions after one or two your classmates presentations.) The oral presentations will be scheduled sometime in November and/or December. Some presentations may need to be scheduled outside of class time. More instructions regarding the project will be handed out during the term. TEXTBOOK: A. Dixit and R. Pindyck, (1994) Investment under Uncertainty, Princeton University Press. This book is available through the Bookstore. OTHER REFERENCES (Where possible I will place these on reserve in the Porter library.) Econ 659, Fall 2012, Course Outline Page 2

3 Forsyth P., An introduction to computational finance without agonizing pain, Available at Hull, John C. (2006) Options, Futures, and Other Derivatives, Pearson, Prentice, Hall. Neftci, Salih N. (2000), An Introduction to the Mathematics of Financial Derivatives, second edition, Academic Press. Ross, Sheldon M. (1999) An Introduction to Mathematical Finance: Options and Other Topics, Cambridge University Press. Schwartz, Edwardo and Lenos Trigeorgis (2001) Real options and investment under uncertainty: classical readings and recent contributions, MIT press Trigeorgis, Lenos (1996) Real Options, Managerial Flexibility and Strategy in Resource Allocation, MIT Press. (available online through the library) TENTATIVE LIST OF TOPICS AND SCHEDULE This list of topics and readings may be adjusted during the term depending on interest and timing. Additional readings may be assigned throughout the term. A * indicates a required reading. Sept 11/13 Lecture Topic Readings 1 2 I. Introduction *Dixit & Pindyck, Ch 1. Traditional investment 1 and 2 theory versus the options Trigeorgis Ch1 approach Hull, Chapter on the 2. Introduction to financial mechanics of options options markets 3. A two period real options example 4. Extending the example to more periods Econ 659, Fall 2012, Course Outline Page 3

4 Sept 18/ II. Stochastic processes and Ito s lemma 1. Introduction to stochastic processes 2. The Wiener process 3. Random walk representation of Brownian motion 4. Ito processes *Hull, Chapters on Wiener Processes and Itos s Lemma, the Black Scholes Merton Model Chapter 3 *Forsyth, Sections 2.5 and 2.6 Various chapters in Neftci Various chapters in Ross Sept 25/27 Oct 2/ Ito s Lemma 6. Jump processes III. Dynamic optimization under uncertainty 1. Dynamic programming and the Bellman equation Contingent claims approach to valuing a risky asset, Black Scholes equation and risk neutral valuation Chapters 4 Trigeorgis Chapters 2 and 3 Oct 9/ Capital asset pricing model 4. Valuing a forward contract Assignment 1 due Oct 9 Paper choice due Oct 11 Any introductory corporate finance text Oct 16/ IV. Simple models of investment valuation and optimal investment timing 1. A basic investment problem when the value of the project follows GBM 2. Comparative statics for the stochastic case Chapters 5 and 6 Econ 659, Fall 2012, Course Outline Page 4

5 Oct 23/25 Oct 30 / Nov 1 Nov 6/ A more realistic investment problem Midterm Oct Extensions of these basic investment problems V. Introduction to numerical methods for solving real option problems * Forsyth, pages and * Hull, Chapter on Basic Numerical Procedures Nov 13/ VI. Industry Equilibrium 1. Competitive Industries Chapters 8 Nov 20/22 Nov 27/ Imperfect competition Assignment 2 due (Nov 20) Presentations,, course evaluation, finishing up lecture material as needed Paper write up due Dec. 3 Chapter 9 EXAMPLES OF PAPERS USING A REAL OPTIONS APPROACH The real options approach can be applied in many different contexts. Below is a sampling of papers, focussing mainly on those analyzing environmental and natural resource topics. These papers may be chosen for your project. (Note each paper may be chosen by one student only.) An overview of the real options literature containing many more references is found in: Eduardo Schwartz and Lenos Trigeorgis, Real Options and Investment under Uncertainty: An Overview, in Real Options and Investment under Uncertainty, Classic Readings and Recent Contributions, E. Schwartz and L. Trigeorgis, editors, MIT Press, Cambridge Mass., Another useful review is found in: Esther Mezey and Jon Conrad, Real Options in Resource Economics, Annual Review of Resource Economics, 2, 33-52, ) Some earlier papers valuing real options a) Michael Brennan and Eduardo Schwartz, Evaluating Natural Resource Investments, Journal of Business, 58, , Econ 659, Fall 2012, Course Outline Page 5

6 b) P. Carr, The valuation of sequential exchange opportunities, Journal of Finance, 5, c) J. Ingersoll and S. Ross, Waiting to Invest: Investment and Uncertainty, Journal of Business, 65(1), d) S. Majd and R. S. Pindyck, Time to Build, Option Value, and Investment Decisions, Journal of Financial Economics, 18, 7-27, e) Robert McDonald and Daniel Siegel, Investment and the Valuation of Firms When There Is an Option to Shut Down, International Economic Review, vol. 26, no. 2, pp , June f) Robert McDonald and Daniel Siegel, The Value of Waiting to Invest International Economic Review, vol. 26, no. 2, pp , June g) James Paddock, Daniel Siegel, James Smith, Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases, Quarterly Journal of Economics, vol. 103, no. 3, pp , August h) Robert Pindyck, Investments of Uncertain Cost, Journal of Financial Economics, 34(1), August 1993, ) Natural resource investments a) Jon Conrad, Wilderness: Options to Preserve, Extract, or Develop, Resource and Energy Economics, 22(3), , July b) Jon Conrad and Koji Kotanis, When to Drill? Trigger Prices for the Arctic National Wildlife Refuge, Resource and Energy Economics, 27( 4), , November Also see the comment and erratum on this article: i) Fackler, Paul L, Comment on Conrad and Kotani, Resource and Energy Economics, 29,(2), , May ii) Conrad, Jon M. And Koji Kotani, Erratum to 'When to Drill? Trigger Prices for the Arctic National Wildlife Refuge', Resource and Energy Economics, 29(3), , September c) M. Insley and M. Lei Hedges and trees: incorporating fire risk into optimal decisions in forestry using a no arbitrage approach, Journal of Agricultural and Resource Economics, 32(3): , December d) Charles Mason, Nonrenewable Resources with Switching Costs, Journal of Environmental Economics and Management, 42, 65-81, Econ 659, Fall 2012, Course Outline Page 6

7 e) Randall Morck, Eduardo Schwartz, and David Strangeland, The Valuation of Forestry Resources under Stochastic Prices and Inventories, Journal of Financial and Quantitative Analysis, 24(4) , December f) Don G. Morgan, Don G; Ben S. Abdallah,; Pierre Lasserre, A Real Options Approach to Forest Management Decision Making to Protect Caribou under the Threat of Extinction, Ecology and Society, 13(1), June 2008 g) Sudipto Sarkar, Optimal fishery harvesting rules under uncertainty, Resource and Energy Economics, 31, , h) Margaret Slade, Valuing Managerial Flexibility: An Application of Real Option Theory to Mining Investments, Journal of Environmental Economics and Management, 41, , ) Environmental investments a) Jon Conrad, Global Warming: When to Bite the Bullet, Land Economics, 73( 2), , b) Gonzalo Cortazar, Eduardo Schwartz, and Marcel Salinas, Evaluating Environmental Investments: A Real Options Approach, Management Science, 44( 8), , Aug c) M. Insley, On the option to invest in pollution control under a regime of tradable emissions allowances, Canadian Journal of Economics, 36(4), , d) Ilhem Kassar and Pierre Lasserre, Species preservation and biodiversity value: a real options approach, Journal of Environmental Economics and Management, 48(2), , September e) Robert Pindyck, Irreversibilities and the Timing of Environmental Policy, Resource and Energy Economics, 22(3), July 2000, f) Franz Wirl, Consequences of irreversibilities on optimal temporal CO2 emission policies under uncertainty, Resource and Energy Economics, 28, , ) Real estate a) Dennis Capozza and Yuming Li, The Intensity and Timing of Investment: The Case of Land, American Economic Review, 84( 4), September 1994, b) Steven R. Grenadier, The Strategic Exercise of Options: Development Cascades and Overbuilding in Real Estate Markets, The Journal of Finance, 51, , Econ 659, Fall 2012, Course Outline Page 7

8 c) George H. Lentz and K.S. Maurice Tse, An optimal pricing approach to the valuation of real estate contaminated with hazardous materials, Journal of Real Estate Finance and Economics, 10, , ) Other a) Steven Grenadier and Allen Weiss, Investment in technological innovations: An option pricing approach, Journal of Financial Economics, 44, , b) Jean-Daniel Saphores, Eric Gravel, Jean-Thomas Bernard, Regulation and Investment under Uncertainty: An Application to Power Grid Interconnection, Journal of Regulatory Economics, 25:2, , c) Sudipto Sarkar, A Real-option Rationale for Investing in Excess Capacity, Managerial and Decision Economics, 30, , Academic Integrity: Academic Integrity: In order to maintain a culture of academic integrity, members of the University of Waterloo are expected to promote honesty, trust, fairness, respect and responsibility. Discipline: A student is expected to know what constitutes academic integrity, to avoid committing academic offences, and to take responsibility for his/her actions. A student who is unsure whether an action constitutes an offence, or who needs help in learning how to avoid offences (e.g., plagiarism, cheating) or about rules for group work/collaboration should seek guidance from the course professor, academic advisor, or the Undergraduate Associate Dean. When misconduct has been found to have occurred, disciplinary penalties will be imposed under Policy 71 Student Discipline. For information on categories of offenses and types of penalties, students should refer to Policy 71 Student Discipline, Grievance: A student who believes that a decision affecting some aspect of his/her university life has been unfair or unreasonable may have grounds for initiating a grievance. Read Policy 70 Student Petitions and Grievances, Section 4, Appeals: A student may appeal the finding and/or penalty in a decision made under Policy 70 Student Petitions and Grievances (other than regarding a petition) or Policy 71 Student Discipline if a ground for an appeal can be established. Read Policy 72 Student Appeals, Academic Integrity website (Arts): Academic Integrity Office (University): Accommodation for Students with Disabilities: Econ 659, Fall 2012, Course Outline Page 8

9 Note for students with disabilities: The Office for Persons with Disabilities (OPD), located in Needles Hall, Room 1132, collaborates with all academic departments to arrange appropriate accommodations for students with disabilities without compromising the academic integrity of the curriculum. If you require academic accommodations to lessen the impact of your disability, please register with the OPD at the beginning of each academic term. Econ 659, Fall 2012, Course Outline Page 9