The effects of abandonment options on operating leverage and forward hedging

Wong, Kit Pong

doi:10.1016/j.iref.2004.10.004

Cited by 12 publications

(8 citation statements)

References 27 publications

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“…Since the seminal work of Robichek and Van Horne (1967), the literature has long recognized the importance of abandonment options to corporate decisions (see, e.g., Brennan and Schwartz, 1985; McDonald and Siegel, 1985; Myers and Majd, 1990; Wong, 2006, 2009). The purpose of this paper is to examine how the presence of abandonment options affects the timing and intensity of investment along the lines of Capozza and Li (1994, 2002) and Bar‐Ilan and Strange (1996, 1999) 1 .…”

Section: Introductionmentioning

confidence: 99%

The Effects of Abandonment Options on Investment Timing and Intensity

Wong

2011

Bulletin of Econ Res

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This paper examines how the presence of an abandonment option affects the timing and intensity of a firm's investment. We develop a continuous-time model wherein a firm is endowed with a perpetual option to invest in a project at any time by incurring an investment cost at that instant. The amount of the investment cost is directly related to the intensity of investment that is endogenously chosen by the firm at the investment instant. The project generates a stream of stochastic revenue flows with a concomitant stream of constant cost flows, both of which increase with the investment intensity. We show that allowing the firm to make an irreversible decision to abandon the project does not affect the firm's optimal investment intensity if the investment cost is totally reversible. Otherwise, the option to abandon the project induces the firm to choose a lower level of investment intensity. Furthermore, we show that the presence of the abandonment option pushes down the firm's optimal investment trigger, thereby hastening the undertaking of the project.

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Section: Introductionmentioning

confidence: 99%

The Effects of Abandonment Options on Investment Timing and Intensity

Wong

2011

Bulletin of Econ Res

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“…Profit Share * at the Presence of the Abandonment Option. For given , substituting (31) and (33) into (35), maximizing (35) at and differentiating (36) with respect to , we can get…”

Section: Optimalmentioning

confidence: 99%

“…Further, from the perspective of corporate behavior and decisionmaking, Tsekrekos [30] studies a firm's optimal entry and exit decisions in the face of uncertainties about future profits and construction periods. Wong [31] investigates the behavior of a competitive firm when the firm has an abandonment option and has an access to a forward market under output price volatility. When the marginal cost is higher than the output price, it is optimal for the firm to exercise the option to exit and cease production.…”

Section: Introductionmentioning

confidence: 99%

The Effects of Abandonment Options on Investment Timing and Profit Sharing of FDI

Zhang

Xue

2017

Discrete Dynamics in Nature and Society

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The paper incorporates cooperative game theory into a real option method in a foreign direct investment setting and examines the operational decisions of a multinational corporation in a cooperative framework, where the corporation is endowed with an abandonment option and shares its profit with the host country. In particular, we investigate how the abandonment options affect the optimal investment timing and the optimal profit share of a foreign direct investment using a real option game method. We show that the flexibility of the abandonment option induces the corporation to investment earlier, which indicates the negative effects on investment trigger. The result is consistent with intuition since the abandonment option provides insurance and thus reduces the overall risk of the project. We also find that the introduction of the abandonment option reduces the optimal profit share in a cooperative framework and in turn the lower profit share increases the investment trigger, thereby having a positive effect on the investment threshold to hinder the investment. By numerical analysis, we find that the overall effect of the abandonment options is inversely related to the investment trigger. These findings provide quantitative analysis about the decisions regarding cooperation in international investment extraction projects.

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“…Myers and Majd (1990) propose a procedure that links a project's economic life to its performance taking into account its abandonment value. This paper is closest in the spirit of Ware and Winter (1988), Moschini and Lapan (1992), and Wong (2004). Ware and Winter (1988) consider the competitive exporting firm under exchange rate uncertainty such that the firm possesses the ex post flexibility in selling to either the domestic market or a foreign market.…”

Section: Introductionmentioning

confidence: 99%

“…In a similar vein, Wong (2004) examines the behavior of the competitive firm under output price uncertainty in the presence of an abandonment option, where the firm is restricted to use forward/futures contracts for hedging purposes. The major concern of Wong's (2004) paper is on the robustness of the celebrated separation and full-hedging theorems emanated from the hedging literature (Danthine, 1978;Holthausen, 1979;and Feder et al, 1980). The separation theorem states that the production decision of the competitive firm is affected neither by the risk attitude of the firm nor by the incidence of the output price uncertainty should the firm have access to a forward/futures market.…”

Section: Introductionmentioning

confidence: 99%

Operating Leverage and the Interaction Between Abandonment Options and Exotic Hedging

Wong¹

2005

J. Deriv. Acct.

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This paper examines the interaction between operational and financial hedging in the context of the competitive firm under output price uncertainty. The firm is endowed with an abandonment option in that its production decision is made after the true realization of the random output price has been observed. If the realized output price is less than its marginal cost, the firm optimally exercises its abandonment option and ceases from production. Otherwise, the firm lets its abandonment option extinguish and produces at its capacity. The existence of the abandonment option is shown to induce the firm to opt for a concave payoff risk-sharing rule that can be perfectly replicated by writing call options with a single strike price set equal to the marginal cost. We derive necessary and sufficient conditions that ensure a positive (negative) effect of operational hedging via the abandonment option on the firm's optimal operating leverage. In contrast, we show that the effect of financial hedging via customized exotic derivatives on the firm's optimal operating leverage is unambiguously positive. These results suggest that the interaction between abandonment options and exotic hedging is multi-dimensional and deserves further scrutiny.

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The effects of abandonment options on operating leverage and forward hedging

Cited by 12 publications

References 27 publications

The Effects of Abandonment Options on Investment Timing and Intensity

The Effects of Abandonment Options on Investment Timing and Intensity

The Effects of Abandonment Options on Investment Timing and Profit Sharing of FDI

Operating Leverage and the Interaction Between Abandonment Options and Exotic Hedging

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