Valuing portfolios of interdependent real options under exogenous and endogenous uncertainties

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Title: Valuing portfolios of interdependent real options under exogenous and endogenous uncertainties
Authors: Maier, S
Pflug, G
Polak, J
Item Type: Journal Article
Abstract: Although the value of portfolios of real options is often affected by both exogenous and endogenous sources of uncertainty, most existing valuation approaches consider only the former and neglect the latter. In this paper we introduce an approach for valuing portfolios of interdependent real options under both types of uncertainty. In particular, we study a large portfolio of options (deferment, staging, mothballing, abandonment) under conditions of four underlying uncertainties. Two of the uncertainties, decision-dependent cost to completion and state-dependent salvage value, are endogenous, the other two, operating revenues and their growth rate, are exogenous. Assuming that endogenous uncertainties can be exogenised, we formulate the valuation problem as a discrete stochastic dynamic program. To approximate the value of this optimisation problem, we apply a simulation-and-regression-based approach and present an efficient valuation algorithm. The key feature of our algorithm is that it exploits the problem structure to explicitly account for reachability – that is the sample paths in which resource states can be reached. The applicability of the approach is illustrated by valuing an urban infrastructure investment. We conduct a reachability analysis and show that the presence of the decision-dependent uncertainty has adverse computational effects as it increases algorithmic complexity and reduces simulation efficiency. We investigate the way in which the value of the portfolio and its individual options are affected by the initial operating revenues, and by the degrees of exogenous and endogenous uncertainty. The results demonstrate that ignoring endogenous, decision- and state-dependent uncertainty can lead to substantial over- and under-valuation, respectively.
Date of Acceptance: 22-Jan-2019
ISSN: 0377-2217
Publisher: Elsevier
Journal / Book Title: European Journal of Operational Research
Copyright Statement: This paper is embargoed until 24 months after publication.
Sponsor/Funder: Commission of the European Communities
Economic & Social Research Council (ESRC)
Funder's Grant Number: 314441 (CELSIUS)
Keywords: MD Multidisciplinary
Operations Research
Publication Status: Accepted
Appears in Collections:Faculty of Engineering
Civil and Environmental Engineering

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