Real Options Approach as a Decision-Making Tool for Project Investments: The Case of Wind Power Generation

Model risk in real option valuation

“…and Muñoz, Contreras, Caamaño, and Correia (2011);Luo, Wang, and Yang (2016) use the net present value of the project's future cash flows.…”

“…Trigeorgis (1996), Smit (1996), , Hahn (2005, 2008) and Smith (2005) all employ decision trees but, unlike us, they assume market-priced risk and thus adopt the RNV framework, avoiding the explicit use of a utility. Mason and Merton (1985), Mason (1987), De Reyck, Degraeve, andVanderborre (2008) and Muñoz, Contreras, Caamaño, and Correia (2011) also use decision trees, but with a constant risk-adjusted discount rate. Only Grasselli (2011) applies a utility function in a decision tree for real option valuation and the exponential (CARA) utility that he applies has substantial limitations -see Section 3.4 for details.…”

“…Indeed, the option values are monotonically decreasing in σ at every µ, and monotonically increasing with µ for every σ. However, 21 A selection of recent literature that supports this relationship includes: Franklin Jr (2015), Chronopoulos, De Reyck, andSiddiqui (2011), Bøckman, Fleten, Juliussen, Langhammer, andRevdal (2008) and Alvarez and Stenbacka (2004) -these assume a GBM price process; Mac Cawley, Cubillos, and Pascual (2018) and Muñoz, Contreras, Caamaño, and Correia (2011) -these papers set a mean-reverting price process; Regarding costs, of course RNV option prices always increase with volatility when these are fixed -but more generally, Mac Cawley, Cubillos, andPascual (2018), Franklin Jr (2015), Chronopoulos, De Reyck, and Siddiqui (2011) and Alvarez and Stenbacka (2004) assume with a fixed or deterministic investment cost, whilst Muñoz, Contreras, Caamaño, andCorreia (2011) andBøckman, Fleten, Juliussen, Langhammer, andRevdal (2008) set the investment cost to be stochastic; for the valuation measure Mac Cawley, Cubillos, andPascual (2018), Franklin Jr (2015), Bøckman, Fleten, Juliussen, Langhammer, and Revdal (2008) and most of the other papers cited here value the option under the risk-neutral measure -exceptions include Chronopoulos, De Reyck, and Siddiqui (2011), who adopt a HARA utility, Alvarez and Stenbacka (2004) consider a concave utility and Muñoz, Contreras, Caamaño, and Correia (2011) employ the physical measure with a risk-adjusted discount rate.…”

“…Among many others:Chronopoulos, De Reyck, and Siddiqui (2011) andAlvarez and Stenbacka (2004) use fixed investment costs; deterministic costs are applied byMac Cawley, Cubillos, and Pascual (2018),Dahlgren and Leung (2015) and Franklin Jr(2015);Choi, Kwak, and Shim (2017) andMuñoz, Contreras, Caamaño, and Correia (2011) have stochastic investment costs; and Fontes (2008) assumes a mixture of fixed and stochastic costs. 17 However, this property only holds under GBM views for market prices, see Section 5.2 for a counter example under different price processes.…”