Real Options With Priced Regime-Switching Risk

Abstract

We develop a model of regime-switching risk premia as well as regimedependent factor risk premia to price real options. The model incorporates the observation that the underlying risky income streams of real options are subject to discrete shifts over time as well as random changes. The presence of discrete shifts is due to systematic and unsystematic risk associated with changes in business cycles or in economic policy regimes or events such as takeovers, major changes in business plans. We analyze the impact of regimeswitching behavior on the valuation of projects and investment opportunities.We find that accounting for Markov switching risk results in a delay in the expected timing of the investment while the regime-specific factor risk premia make the possibility of a regime shift more pronounced.

Defining the Black and Scholes approach: a first systematic literature review

“…For the period between 1999 and 2015, we found that this method has been applied to many cases and in many different fields, from the evaluation of construction projects (Barton & Lawryshyn, 2011;Ford et al, 2002;Garg & Kumar, 2014;Jiao et al, 2007;Oppenheimer, 2002;Parthasarathy & Madhumathi, 2010;Sewalk & Dai, 2014); investments in R&D (Kumaraswamy, 1996;Ming-Cheng & Yen, 2007), in particular those by pharmaceutical companies (Gunther McGrath and Nerkar, 2004;Hartmann & Assan, 2006); the evaluation of IT (information technology) projects (Benaroch, 2002;Fichman, 2004); insurance portfolio strategies; customer relationship management (Maklan et al, 2005); the management and evaluation of intagible assets (Bhattacharya & Wright, 2005, Faiferlick et al 2004, Park et al, 2013; and the assessment of bonds and derivatives (Driffill et al, 2013;Ericsson & Reneby, 2005;Fabozzi et al, 2012, Pyo, 2008Ren-Raw et al, 2002;Singh, 2014, Tompkins, 2001). …”

Irreversible Investment under Competition with a Markov Switching Regime

“…We need to take the regime shift into account to derive the value function for each regime. The procedure is exactly the same as Driffill et al (2009) and thus refer to their paper for a detailed discussion. First, for P ≥P i F 2 , firm i immediately invest in the project regardless of the realized regime.…”

“…Typically, regime uncertainty is modeled in a way that parameters describing the state variables follow a Markov chain as in Driffill et al (2003), Guo et al (2005) and Hackbarth and Miao (2011). Among them, Driffill et al (2009) study the investment decision for a project whose risk premia and other exogenous parameters are subject to a stationary Markov chain. They derive a simultaneous ordinary differential equation system that can calculate an investment threshold for each regime.…”

“…In other words, a Markov switching regime as in Driffill et al (2009) is introduced into the model of Pawlina and Kort (2006). To the authors' best knowledge, this paper is the first attempt to combine the competitive real options model with a Markov switching regime.…”

Leaders, followers, and equity risk premiums in booms and busts

“…Typically, regime uncertainty is modeled in a way that parameters describing the dynamics of the state variables follow Markov switching. Among them, Driffill et al (2013) study the investment decision of a project with Markov-modulated geometric Brownian motions. They derive a simultaneous ordinary differential equation system that can calculate an investment threshold for each regime.…”