real options valuation

real options valuation

(Parte 1 de 6)

Real Options Valuation Real Options Valuation

Marcus Schulmerich

Real Options Valuation

The Importance of Interest Rate Modelling in Theory and Practice

Second Edition

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Springer is part of Springer Science+Business Media (w.springer.com) Printed on acid-free paper

Springer Heidelberg Dordrecht London New York # Springer-Verlag Berlin Heidelberg 2005, 2010

The use of general descriptive names, registered names, trademarks, etc. in this publication does not

ISBN 978-3-642-12661-1 e-ISBN 978-3-642-12662-8 DOI 10.1007/978-3-642-12662-8

Cover design: WMXDesign GmbH

Dr. Marcus Schulmerich, CFA, FRM Vice President State Street Global Advisors (SSgA) Brienner Strasse 59 80333 Munich

Germany marcus.schulmerich@alum.mit.edu

Library of Congress Control Number: 2010932875 or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965,

To my parents. To my parents.

Preface to the Second Edition

After the first edition of this book was published in early 2005, the world has changed dramatically and at a pace never seen before. The changes that occurred in 2008 and 2009 were completely unthinkable two years before. These changes took place not only in the Finance sector, the origin of the crisis, but also, as a result, in other economic sectors like the automotive sector. Governments now own substantial parts, if not majorities, in banks or other companies which recorded losses of double digit billions of USD in 2008. 2008 saw the collapse of leading stand-alone U.S. investment banks. In many countries interest rates fell close to zero. What has happend?

While the economy showed strong growth in 2004 to 2006, the Subprime or Credit Crisis changed the picture completely. What started in the U.S. housing market in late 2006 became a full-fledged global financial crisis and has affected financial markets around the world. A decline in U.S. house prices and increasing interest rates caused a higher rate of subprime mortgage delinquencies in the U.S. and, due to the wide distribution of securitized assets, had a negative effect on other markets. As a result, markets realized that risks had been underestimated and volatility increased. This development culminated in the bankruptcy of the investment bank Lehman Brothers in mid September 2008. Consequently, credit spreads widened and the depth of the crisis led to the absence of prices and secondary markets for structured credit products. The uncertainty as to where losses were hidden in the financial services sector disrupted money markets and caused funding problems for several institutions. The hesitancy of banks to lend to each other forced a number of central banks to provide large amounts of liquidity to markets and institutions, in order to counteract this development.

What had started to be a controllable event in the Finance industry spilled over to the real world economy in the second half of 2008, pulling the world close to an abyss. The countries to suffer most from this crisis, both in the Finance sector and in the real world sectors, were the U.S. and Great Britain. One reason for this is clearly their dependency on investment banking.

viii Preface to the Second Edition

Investment banks like Bear Stearns and Lehman Brothers, giants like Fannie Mae and Freddie Mac or financial institutions like IKB in Germany (almost) went bankrupt. In addition, many hedge funds needed to reduce their leverage ratio in the second half of 2007 due to liquidity problems. This triggered the so called ”Quant Crisis” for equity portfolios that are managed by using mathematical models and that invest in developed market stocks. To make things worse, growth staggered at the end of 2007 and big economies like the U.S. or Germany showed signs of a recession. All the negative estimates on growth for 2008 and 2009 were exceeded by even more negative real economic data.

Threats to the economic growth and an increased inflation are alarming signs for central banks, and when growth weakened at the end of 2007, the Federal Reserve in the U.S. reduced the interest rates in rapid steps. Interest rate history has thus repeated itself by completing a full cycle of market movements.

This was reason enough to look at the real options analysis again, 6 years after the first edition of the book had been written. Now, a longer historical time period can be covered, and more studies with historical backtests can be provided. Therefore, the findings of the first edition of this book, which were based on the analysis of data from April 1997 to March 2003, were put to the test again. Do they still hold true, if the research period is extended to March 2009? This is the focal question of this second edition.

The general answer is yes. In order to arrive at this conclusion, many new historical backtests had to be conducted. The backtests now cover a time period which is longer by 6 years and spans from April 1997 until March 2009. The complete analysis and interpretation of these new backtests can be found, as in the first edition, in Chapter 5.8.

I want to close this preface with special thanks to the EUROPEAN BUSINESS SCHOOL - ebs in Oestrich-Winkel. At the ebs I completed my research for the first edition of this book and I also completed my research for the second edition. This was possible since I have served the ebs as a guest lecturer for the two courses ”Financial Engineering” as well as ”Derivatives and Risk Management” since 2005 as part of the Endowed Chair for Asset Management.

The research was done besides my work at the institutional asset management company State Street Global Advisors (SSgA) where I have worked since mid 2006 as the Senior Product Engineer in Europe for Enhanced and Active Quant Equity Portfolio Management.

May 2010, Marcus Schulmerich

Foreword to the First Edition

Managerial decision-making during the lifetime of a project can have important implications on project handling and its contribution to shareholder value. Traditional capital budgeting methods (in particular methods based on net present value) fail to capture the role of managerial degrees of freedom and therefore tend to lead to a systematic undervaluation of the project. In contrast, the real options approach to investment analysis characterizes decision-making flexibility in terms of (real) option rights which can be evaluated analogously to financial options using contingent-claims pricing techniques widely used in capital markets.

The research carried out by Marcus Schulmerich analyzes real options for nonconstant and stochastic interest rates versus constant interest rates. Analyzing stochastic interest rates in the context of real options valuation is of particular relevance given their long time to maturity which makes them more vulnerable to interest rate risk than short-term financial options. To date, there has not been a comprehensive review of this issue in the academic literature. The fact that interest rates have fluctuated widely over the recent years further highlights the need for studying this issue.

This study incorporates variable and stochastic interest rates into numerical approaches to real options valuation and analyzes the implications for the efficiency of these numerical methods. The author starts out by providing a critical review of the approaches taken in the literature to value complex real option rights and adopts a pragmatic approach in expanding them. He is specifically interested in assessing to what extent the assumption of a constant discount rate frequently observed in corporate practice leads to wrong investment decisions. Although capital market experts would at no point assume interest rates to be constant, this issue has only been marginally addressed in the real options literature. However, as the author points out, unexpected shifts in the interest rate curve will often exert a lasting influence on the value-oriented control of projects.

x Foreword to the First Edition

The main part of the study presents extensive numerical simulations and the historical backtests for various complex real option rights by combining standard numerical modelling techniques for real options and interest rate risk. Following introductory assessments on the efficiency of standard numerical valuation methods and the possibility of extending these methods to non-constant interest rates, the author looks at various equilibrium and no-arbitrage models for interest-rate modelling in real options valuation. A concluding section examines the additional benefit achieved by including nonconstant interest rates in real options valuation through historical backtesting. Alongside stochastic interest rates, models with constant interest rates or implicit forward interest rates are analyzed. The simulation results provide important numerical findings for the first time indicating the extent to which the common assumption of constant interest rates in valuation practice can actually be justified. It turned out that it is important to adjust for the shape of the term structure in real options valuation, even if interest rates are modelled stochastically. In methodological terms, stochastic interest rate models should be preferred, although their additional benefit over using implicit forward rates is not verifiable. In fact, the use of implicit forward rates is overall preferable, especially given the ease of applying these models in corporate practice. Along the same lines, the assumption of constant interest rates should be rejected on principle.

This research study by Marcus Schulmerich generates new knowledge for capital market research and corporate valuation practice and develops guidelines for their practical implementation. The book closes an important gap in the literature and represents a valuable contribution to answering the question how real options insights can effectively be employed to improve the quality of valuation exercises and thereby real investment decisions. We hope that the study will be widely disseminated and that it will receive the attention it deserves by academics as well as practitioners.

May 2005

Cambridge, MA, USA Prof. Stewart C. Myers, Ph.D. Oestrich-Winkel, Germany Prof. Ulrich Hommel, Ph.D.

Preface to the First Edition

This preface is dedicated to all the people and institutions without whom the completion of my doctoral thesis would not have been possible. I want to thank all the people involved in this thesis; I want to thank all the academic institutions that gave me my education and allowed me to use their facilities; and I want to thank Commerzbank for supporting my research by granting me a 10-week leave of absence in fall 2002 to work on my thesis full-time, a time I spent at Harvard Business School.

This thesis could not have become a reality without the ongoing support of several people. First of all, my thanks go to Prof. Ulrich Hommel, Ph.D., my thesis advisor at the EUROPEAN BUSINESS SCHOOL - ebs (Endowed Chair for Corporate Finance and Capital Markets) in Oestrich-Winkel, Germany. His critique during the last three years provided the right mixture of motivation, challenge, and support to bring the thesis to a successful end. He always allowed me to follow my own ideas as to how to pursue the research, yet put me back on the right track whenever necessary. Moreover, he demanded results, which pushed my research forward sufficiently to enable me to finish the thesis within the timeframe we both had in mind. Finally, I want to thank him for the opportunity to publish parts of this thesis in his latest book on real options in corporate practice (see Hommel, Scholich & Baecker [60]). Additionally, my thanks go to Prof. Dr. Lutz Johanning, head of the Endowed Chair for Asset Management at ebs for his valuable feedback during my research period and for being one of the evaluators of this thesis.

I also want to thank Mischa Ritter and Philipp N. Baecker, both doctoral candidates of Prof. Hommel. My long and fruitful discussions with Mischa Ritter helped to shape the focus of this thesis and gave several new twists to my research and the writing of the thesis. Philipp N. Baecker’s experience in quantitative modelling of real options proved a great resource of new ideas and research directions as well, especially during several doctoral workshops at the ebs. Moreover, his help was extremely valuable in expressing my ideas in TEX, a passion of his, Prof. Hommel’s, and mine.

xii Preface to the First Edition

Last but not least I would like to thank Gudrun Fehler, the secretary to the Endowed Chair for Corporate Finance and Capital Markets at ebs for proofreading the final version of this thesis with enthusiasm and diligence. Of course, all the remaining errors you will find on the following pages are entirely my fault.

Besides the people at ebs mentioned so far several others contributed tremendously to this thesis. First, I want to thank Prof. Stewart C. Myers, Professor of Economics, Finance, and Accounting at the Sloan School of Management at the Massachusetts Institute of Technology, MIT. He introduced me to the exciting world of Corporate Finance and Capital Markets during my studies at MIT’s Sloan School where I studied for the MBA from 1999 to 2001. His course 15.401-Finance I gave me the ”first contact” with Finance Theory. He is also one of the evaluators of this thesis.

The introductory Finance course by Prof. Myers was followed by many others. Especially, I want to mention the courses Options and Futures as well as Investment Banking (which could also be called Fixed Income Securities Valuation, since this was its only content) taught by Prof. John C. Cox. His way of presenting the material as well as his openness to students and their questions, in and outside of the classroom, were among the lasting memories I took from my studies at MIT Sloan. When my ideas of pursuing a doctorate in Finance began to shape, his input in considering possible topics helped me a lot to find the direction of my research.

While at Harvard Business School during Fall semester 2002, I also got a great deal of input for my research from Prof. Li Jin, Assistant Professor of Finance at Harvard. He invited me to be his Research Assistant for one semester, allowing me to devote my time entirely to my research and thesis writing. He also proofread the initial work and gave me valuable suggestions that shaped the look of my thesis. Many thanks are dedicated to him, his efforts and support during the time I was working on the thesis at Harvard Business School.

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