Tero Haahtela

Recombining Trinomial Tree for Real Option Valuation with Changing Volatility

This paper presents a recombining trinomial tree for valuing real options with changing volatility. The trinomial tree presented in this paper is constructed by simultaneously choosing such a parameterization that sets a judicious state space while having sensible transition probabilities between the nodes. The volatility changes are modeled with the changing transition probabilities while the state space of the trinomial tree is regular and has a fixed number of time and underlying asset price levels. The presented trinomial lattice can be extended to follow a displaced diffusion process with changing volatility, allowing also taking into account the level of the underlying asset price. The lattice can also be easily parameterized based on a cash flow simulation, using ordinary least squares regression method for volatility estimation. Therefore, the presented recombining trinomial tree with changing volatility is more flexible and robust for practice use than common lattice models while maintaining their intuitive appeal.

PROFIT AND RISK SHARING IN A VIRTUAL ENTERPRISE

Organizations are increasing the use of partnerships but improved models addressing the sharing of profits and risks are needed to foster innovations in networked new product development. We have used a case study approach to explore the implementation of profit- and risk-sharing mechanisms in a virtual enterprise. Lack of a shared vision may have been the most important cause for the early decomposition of the virtual enterprise. Therefore, the trust did not start to accumulate during the cooperation. This would have been imperative for the implementation of profit sharing mechanisms, because risk attitudes seemed to favor hierarchical rewarding mechanisms.

Estimating Changing Volatility in Cash Flow Simulation Based Real Option Valuation with Regression Sum of Squares Error Method

This paper presents a practical volatility estimation method for cash flow simulation based real option valuation with changing volatility. During cash flow simulation, present value of the future cash flows and their corresponding cash flow state variable values are recorded for all time periods. Then, for each time period, regression analysis is used for relating the present value to the cash flow state variables of the same time period. Each regression equation provides an estimate of the expected present value as a function conditioned on the resolution of all uncertainties up to that time. Then, basic regression statistics of Pearson’s correlation R2 and sum of squares error (or standard error) for each equation provide all the information required for estimating how the standard deviation and volatility of the stochastic process change over time. The method is computationally efficient because it requires only one pass of simulation runs regardless of the number of time periods. It can also handle negative underlying asset values. Straightforward calculation of required regression statistics and their availability in any statistical software and even in spreadsheet programs make this approach very easy to apply for a practitioner.

Sensitivity Analysis for Cash Flow Simulation Based Real Option Valuation

Sensitivity analysis identifies the critical aspects of the investment model that affect model output uncertainty. Common sensitivity analysis on options considers how the solution changes as a result of change in one of the key parameters (underlying asset value, volatility, exercise price, interest rate, time to maturity, dividends). In case of cash flow simulation based real options, these are mostly indirect variables that are computed based on the primary input variables – demand, unit selling price, and unit costs – in the cash flow calculation. The method presented in this paper combines the uncertainties in the underlying asset together by simulation, and then uses regression analysis approach for estimating how a change in a primary variable or variables affects simultaneously the stochastic process parameters of expected value and volatility during different time periods. As a result, the presented method shows how a change in a primary variable affects project value with real options. This information is also essential as it shows decision makers which uncertainties to follow, and thus this mitigates the common black box syndrome of consolidated cash flow simulation based methods.

Cash Flow Simulation Embedded Real Options

Cash flow simulation embedded option is an option whose value is based on choosing the optimal decision in each time step during a single cash flow calculation simulation run. Cash flow simulation embedded options are mostly operative options with continuous, gradual and nearly immediate exercise with well-known payoff or benefits. Typically these options are difficult to model with other methods than Monte Carlo simulation. However, cash flow simulation embedded options and the common, once exercisable options can be applied simultaneously in an investment valuation by using the simulated cash flow with embedded options as the underlying asset for the lattice, which is then used in valuing other lattice type options and their interactions.

Perspectives on demonstration pathways in the sociotechnical transition of electric mobility in Finland

A model of sociotechnical change takes into account different sociotechnical configurations and their interactions in a multi-level framework consisting of three major levels: niche innovations, a sociotechnical regime and a sociotechnical landscape. The sociotechnical changes can be analysed by studying the transition pathways along different multi-level interactions. The pressure from the landscape level and niche-innovations from the bottom level reinforce the relationships and operations on the regime level. This paper discusses the results of the study and illustrates the on-going development and the future changes in sociotechnical regimes of electric mobility in Finland. The regime changes have been analysed using a three-level perspective. The levels comprise an industry level, a value networks level and an enduser level. The results of the regime analysis show that there is a great deal of uncertainty in the operation environment and that new actors and new business models are needed to for the system to work properly. According to earlier research, sociotechnical transition pathways can be categorised based on the environmental change and the type of transition. In the case of electric mobility, the transition does not fit directly with any of the category types. Electric mobility will most likely follow the reconfiguration transition pathway. The changes in Finland are taking place slowly. This development can be aggregated via governmental support and incentives for organisations and consumers.

Value of a Protective Abandon Put Option for Investors of Small and Large Firms with Different Capital Structures

This paper investigates the value of protective abandon put option from the equity holder’s perspective of a large and a small company. Motivation for this topic arises from the perception that certain market imperfections related to corporate and personal taxes tend to favor a large firm and its investors if there is a risk of a loss or even bankruptcy. Using a flow-to-equity model this paper investigates how these market imperfections affect the project value with and without a protective put option with different capital structures. Because the put option causes asymmetry to the project payoff, semivariance is used as a risk measure instead of the commonly used variance. The results of the analysis indicate that a protective put option is more valuable to small company investors because it narrows the downside risk and thus enables better capital structure and mitigates certain imperfections of taxation. However, as long as there is a risk of loss, large firms and their investors have a tax advantage and thus they value a similar project as being more valuable.