Doctoral thesis

Three essays in real options


101 p

Thèse de doctorat: Università della Svizzera italiana, 2010 (jury note: magna cum laude)

English Real options refer to the investment, entry, exit and other strategic decisions of the firm that share three important characteristics: they are irreversible, they are made under uncertainty, and their timing is chosen by the firm. The term `real options' was introduced in 1977 by Stewart Myers in his paper `Determinants of corporate borrowing' that related risky debt holdings to the future investment policy of the firm. The literature on real options has since been active and growing with seminal works by Brennan and Schwartz (1985) on the valuation and optimal timing of the natural resource investments; McDonald and Siegel (1986) on general approach to investment timing and scrapping; Margrabe (1978) on the asset exchange options; Fudenberg and Tirole (1985) on the preemption and equilibrium in the technology adoption games; Pindyck (1988) on capacity choice, and Kulatilaka and Perotti (1998) on strategic growth options under imperfect competition. In the 1990's and 2000's, a number of classical textbooks in real options appeared in print: Dixit and Pindyck (1994), Trigeorgis (1996), Amram and Kulatilaka (1998), and Vollert (2003). In its development the real options literature combines the option pricing framework introduced in Black and Scholes (1973) and Merton (1973) with the research in the specific fields of economics and finance such as capital budgeting and investment policy, corporate debt and agency problems, mergers & acquisitions or game theory. The present work illustrates the application of the real options approach to three economic areas: strategic competition, mergers & acquisitions and international trade. The first chapter discusses the optimal timing of the technology adoption, entry and merger decisions in the industry producing a vertically differentiated product. I solve the model for the monopoly, duopoly and merger (which is equivalent to a monopoly with two products) and outline the equilibrium strategies of the Incumbent and the Entrant. In particular, I demonstrate that the Incumbent under the threat of entry always invests in the cost-reducing technology later as compared to the no-threat-of-entry (monopoly) case. This results in the lower option value to the Incumbent under duopoly. The monopolistic problem is investigated using two alternative specifications for the price of the new technology: in the first case, the price of the technology is constant, whereas in the second, more general case, the price of the new technology is increasing in the amount of cost reduction it provides. I demonstrate that the increasing investment cost (price of the technology) makes the Incumbent postpone the technology adoption as compared to the constant price situation. Besides, increasing investment cost reduces the option value to the Incumbent. I demonstrate that the merger generates the endogenous synergy in this model. I prove that the merger may not only increase the option value to the Incumbent as compared to the monopoly case, but it may also give the Entrant the opportunity to finally enter the market as a part of the merged firm whereas its independent entry would be unprofitable. The second chapter investigates the connection between the market valuation and a type of the merger (stock, cash). I solve explicitly for the timing and terms of cash mergers in two different settings to demonstrate that cash mergers generally take place at low market valuations, whereas stock mergers may be observed at both low and high valuations. This result holds with some differences for both dynamic settings and conforms to the empirical evidence on mergers. In the second setting I solve the model employing the Least Squares Monte Carlo simulation approach developed by Longstaff and Schwartz (2001). I also study the dynamics of the intra-industry mergers within the first setup. I solve for the optimal order of mergers inside the industry. Using three different initial capital allocations within the industry, I demonstrate that stock mergers in more concentrated industries occur at higher market valuation (i.e. later) as compared to mergers in less concentrated industries. In the third chapter I investigate the problem of the exporter who faces the exchange rate appreciation and, consequently, decrease in profits since its export prices are denominated in the currency of the country of destination. The exporter has a number of opportunities to renegotiate the export prices paying fixed menu costs each time. I solve the problem employing the real options approach for both infinite and finite horizon. I demonstrate that even small menu costs may contribute to the export price stickiness. I provide the closed-form expressions for the export price adjustment thresholds and explicitly compute the option value of performing an infinite number of export price adjustments for the infinite horizon problem. For the finite horizon problem, I use the binomial tree method to approximately estimate option values and derive the exercise boundaries of the first export price adjustment. I also provide simulation results to show that the aggregate price in the market of destination is much less volatile than the exchange rates for the respective exporters.
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