James A. Conover

Valuing Flexible Manufacturing Facilities as Options

Models for valuing an option to exchange one commodity for another, or any combination of n input commodities for some combination of m outputs, are applied to the capital budgeting problem, making it possible to draw sound conclusions about the valuation effects of flexibility and innovativeness. New algorithms enable practical application of the model to complex flexible manufacturing facilities. Careful attention to estimating the matrix of correlations among the prices of potential inputs and outputs involves explicit integration of financial analysis and strategic analysis especially the influence of substitutes and the anticipated reactions of competitors, suppliers, and potential new entrants.

Efficient Selection of Insured Currency Positions: Protective Puts vs. Fiduciary Calls

We examine the empirical results from implementation of portfolio insurance strategies employing currency spot and futures options. Hypotheses are generated from Ogden and Tuckers (1988) generalizations concerning the relative values of American spot currency options and currency futures options. We find that protective puts using futures options are generally dominated by both protective puts that use options on spot currencies and by fiduciary calls on futures contracts. This suggests that the prices of puts on foreign currency futures contracts are too high, relative to foreign currency futures calls and to puts on spot currencies.

Voluntary disclosure of real options: When and how it can be done

It is fundamental to good governance that corporate decision makers be well informed, have the knowledge-base necessary to use the information effectively, and share the same motivations as the owners. Further, managers must provide owners with accurate, timely, and complete disclosure of the company’s positions. Regarding the first part of the problem, value based incentive systems have been under development in order to aid in resolving conflicts of interest between owners who lack the specific information (or the background knowledge to utilize it) and the managers who act as their agents. Such systems often focus exclusively upon cash flows relative to resource investment; yet, share values are often substantially greater than the amount that could be explained by expected cash flows from existing operations. Indeed, in some firms the majority of share value may de rive from growth opportunities or other real options that add flexibility or reduce risk. So, value based incentive systems could be improved by explicitly rewarding actions that create or enhance the firm’s real options. Further, satisfactory disclosure requires that accounting reports include adequate information about the firm’s real options, with market-based mechanisms for defining the necessary information and calling it into the appropriate arena.

Risk and the miller equilibrium: Capital structure choice with risk-averse investors

Merton Millers (1977) tax model of equilibrium capital structure choice results in capital structure irrelevance and the existence of tax clienteles, assuming the restrictive case of risk-neutrality. Relaxation of the assumption of risk-neutrality in Millers tax framework, allowing utility-maximizing risk-averse investors, indicates that capital structure irrelevance continues to hold under reasonable assumptions about utility. Evaluation of resulting tax clienteles shows that marginal tax rates do not restrict investors from investing in equities but do affect the tax status of purchased bonds.

Does it Pay to Forecast the Business Cycle? A U.S. Update and an International Perspective

Over the period 1970-2015, investment returns were enhanced by merely knowing concurrently whether the economy was in a state of expansion or contraction, and making the most basic asset allocation decision of whether to be in stocks or bonds. In the United States, an annual excess return of 2.01% was earned by investing in stocks during expansions and in bonds during contractions. In eight foreign markets, the average annual excess return from the same strategy was 1.74%. Forecasting business cycle troughs is more important than business cycle peaks. The authors conclude simple passive timing improves fund performance using business cycle peaks/troughs, and even slight forecasting prowess is rewarded with positive performance. Importantly, even investors who invested one month after the cycle turns could still earn excess returns.

Options to Choose Among the Most Profitable of Several States in the Physical Realm and the Information Realm

Abstract Option models have provided insight into the value of flexibility to switch from one state to another (such as switching a mine or refinery from operating to closed status). More complex flexible processes offer multiple possibilities for switching states. A fabrication facility, for example, may offer options to shift from the current status to any of several alternatives (reflecting reconfiguration of basic facilities to accommodate different operating processes with different outputs). New algorithms enable practical application of complex option pricing models to flexible facilities, improving analysts’ ability to draw sound conclusions about the effects of flexibility and innovativeness on share value. Such models also apply for options with information items as the underlying assets. Information organizations such as oil exploration and development companies may include options to shift from the current capability to any of several alternatives reflecting added abilities to handle new information sources or apply the organization’s talents in new ways. In the case of either physical or information processing, careful attention to estimating the matrix of correlations among the values of potential alternative states allows explicit integration of financial analysis and strategic analysis – especially the influence of substitutes and the anticipated reactions of competitors, suppliers, and potential new entrants.

Extending the real options approach by including information options

Analysis of Information Options offers new tools for evaluating investments in research, mineral exploration, logistics, energy transmission, and other information operations. With Information Options, the underlying assets are information assets and the rules governing exercise are based on the realities of the information realm (infosphere). Information Options can be modeled as options to “purchase” information assets by paying the cost of the information operations involved. Information Options arise at several stages of value creation. The initial stage involves observation of physical phenomena with accompanying data capture. The next refinement is to organize the data into structured databases. Then bits of information are selected from storage and synthesized into an information product (such as a management report). Next, the information product is presented to the user via an efficient interface that does not require the user to be a field expert. Information Options are similar in concept to real options but substantially different in their details, since real options have physical objects as the underlying assets and the rules governing exercise are based on the realities of the physical world. Also, while exercising a financial option typically kills the option, Information Options may include multiple exercises. Information Options may involve high volatility or jump processes as well, further enhancing their value. This chapter extends several important real option applications into the information realm, including jump process models and models for valuing options to synthesize any of n information items into any of m output assets.

Chapter 5 Enhancing the Role of Real Options in Financial Decision Making: Buying and Selling Real Options

Perhaps the most difficult objection raised by skeptics of the real options approach concerns the apparent lack of market transactions that would verify that real options have actual value. Although there are no organized exchanges with publicly disclosed prices, there are nevertheless several mechanisms for buying and selling real options. Observing these could offer important advantages in the quest for enhancing the role of real options in financial decision making:•demonstrate that real options can indeed add value•in some cases even gain a sense of the amount of value added by real options•offer expert appraisers methods for improved estimation of the value of a business when real options are part of the organizational capital The most frequently used method for buying or selling real options occurs when a product that includes real options is sold to customers (often at a premium above the price of a comparable product that does not include real options). Real options that are part of the organizational capital of a business are part of the package in an acquisition (or minority equity position). In this chapter we examine several cases of such transactions.