Mark B. Shackleton

How Real Option Disinvestment Flexibility Augments Project Npv

In this article by drawing together existing option pricing models we demonstrate how different degrees of managerial flexability can affect the value of a project. In particular we also include new option pricing results that allow us to properly take into account a firms exit option. Our paper illustrates that these disinvestment options can be valuable suggesting that managerial pessimism (i.e. consideration of outcomes if the project does not perform) can add value.

Cojumps in Stock Prices: Empirical Evidence

We examine contemporaneous jumps (cojumps) among individual stocks and a proxy for the market portfolio. We show, through a Monte Carlo study, that using intraday jump tests and a coexceedance criterion to detect cojumps has a power similar to the cojump test proposed by Bollerslev et al. (2008). However, we also show that we should not expect to detect all common jumps comprising a cojump when using such coexceedance based detection methods. Empirically, we provide evidence of an association between jumps in the market portfolio and cojumps in the underlying stocks. Consistent with our Monte Carlo evidence, moderate numbers of stocks are often detected to be involved in these (systematic) cojumps. Importantly, the results suggest that market-level news is able to generate simultaneous large jumps in individual stocks. We also find evidence of an association between systematic cojumps and Federal Funds Target Rate announcements.

Finite Maturity Caps and Floors on Continuous Flows

In this paper we produce formulae to finitely lived options which allow the holder to chose continually between two flows. For this real option that allows frequent and costless switching between two assets, we examine perpetual and then finite values using a risk neutral annuity argument. Applications include energy and commodity consumption costs where switching between flows can occur frequently and costlessly.Models of interest rate caps and floors are typically based on discrete rates over finite horizons while existing real option models describe perpetual claims on the maximum of two continuous flows. In this paper, we produce formulae for finite maturity caps and floors that are contingent on continuous flows. We present hedge ratios and discuss applications where a lognormally distributed flow variable is suitable. For other situations where practitioners use proprietary models, the formula presented is useful as a quick, tractable and universal means for mapping quoted implied to prices and vice versa.

Surprise vs. Anticipated Information Announcements: Are Prices Affected Differently? An Investigation in the Context of Stock Splits

We compare the long run reaction to anticipated and surprise information announcements using stock splits. Although there is underreaction in both cases, anticipated splits are treated differently to those that are unforeseen. After anticipated splits, cumulative abnormal returns peak at one-and-a-half times the level observed after unanticipated splits although the time taken for the announcement to be absorbed into prices is the same. We explain the difference in underreaction by the degree to which split announcements are believed and hence invested in. The favorable signal conveyed in forecast splits is more credible owing to their better pre-split performance, resulting in a far more pronounced underreaction effect.

Evaluating Natural Resource Investments under Different Model Dynamics: Managerial Insights

We focus on factors that drive the dynamics of commodity prices. We highlight the capital budgeting implications of three highly-cited, nested, multi-factor models for commodity prices that have been successful in empirical investigations. Competing assumptions regarding commodity prices and their convenience yields can account for differences close to 40% on average, and in excess of 60% in cases, in the valuation of typical natural resource investments. These value differences are found to increase with the maturity and the intrinsic value of the investment, and also with the level and the volatility of the resources convenience yield. Resources such as oil or copper, that are used for production purposes, usually exhibit high and volatile convenience yields; thus our findings should be more relevant for decision-makers in such sectors.

Hysteresis Effects Under CIR Interest Rates

Most decision making research in real options focuses on revenue uncertainty assuming discount rates remain constant. However, for many decisions revenue or cost streams are relatively static and investment is driven by interest rate uncertainty, for example the decision to invest in durable machinery and equipment. Using interest rate models from Cox et al. (1985b), we generalize the work of Ingersoll and Ross (1992) in two ways. Firstly, we include real options on perpetuities (in addition to zero coupon cash flows). Secondly, we incorporate abandonment or disinvestment as well as investment options, and thus model interest rate hysteresis (parallel to revenue uncertainty in Dixit (1989a)). Under stochastic interest rates, economic hysteresis is found to be significant, even for small sunk costs.

Empirical pricing kernels obtained from the UK index options market

Empirical pricing kernels for the UK equity market are derived as the ratio between risk-neutral densities, inferred from FTSE 100 index options, and historical real-world densities, estimated from time series of the index. The kernels thus obtained are almost compatible with a risk averse representative agent, unlike similar estimates for the US market.

Pricing options with American-style average reset features

This study extends the Hull and White (1993 J. Derivatives 1 21-31) binomial method to construct a trinomial model for the valuation of American-style options whose strike price can be reset to a new level. The reset criterion is conditioned upon the average underlying asset price hitting the reset barrier in a specified period although the model proposed can accommodate other features. For prices benchmarked against ordinary Asian options, we investigate the difference between a daily reset warrant and a period-average reset warrant and find that the number of time steps between observations affects the value of American-style average price options and period-average reset options.

The simplest American and Real Option approximations: Geske-Johnson interpolation in maturity and yield

The American early exercise feature of the Real Option to invest in a new project is important in capital budgeting and project valuation. Closed form solutions for American, and therefore Real, Options are known for two special cases; an infinite horizon generates the Merton (Bell Journal of Economics, 4, 141–83, 1973) solution while a zero dividend yield on the project generates Black-Scholes (Journal of Political Economy, 81, 637–59, 1973) prices since early exercise is never optimal. Geske–Johnson (Journal of Finance, 39, 1511–24, 1984) approximation is extended to a bivariate case by assuming various forms of separability for option prices as a function of time to maturity and yield to produce fully explicit and asymptotically correct approximations. These methods are compared with another simple approximation method due to Barone-Adesi and Whaley (Journal of Finance, 42, 301–20, 1987) and MacMillan (Advances in Futures Options and Research, 2, 117–42, 1987) and the estimated error these expressions contain compared to an accurate numerical benchmark technique.

Distinguishing short and long memory volatility specifications

Asset price volatility appears to be more persistent than can be captured by individual, short memory, autoregressive or moving average components. Fractional integration offers a very parsimonious and tempting formulation of this long memory property of volatility but other explanations such as structural models (aggregates of several autoregressive components) are possible. Given the ability of the latter to mimic the former, we investigate the extent to which it is possible to distinguish short from long memory volatility specifications. For a likelihood ratio test in the spectral domain, we investigate size and power characteristics by Monte Carlo simulation. Finally applying the same test to Sterling/Dollar returns, we draw conclusions about the minimum number of structural factors that must be present to mimic the long memory volatility properties that are empirically observed.