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Valuing Modularity as a Real Option

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Author Info

  • Andrea Gamba

    ()
    (School of Business, George Washington University, Washington, DC 20052; and Department of Economics, University of Verona, 37129 Verona, Italy)

  • Nicola Fusari

    ()
    (University of Lugano, 6900 Lugano, Switzerland; and Swiss Finance Institute, 1211 Geneva, Switzerland)

Abstract

We provide a general valuation approach for capital budgeting decisions involving the modularization in the design of a system. Within the framework developed by Baldwin and Clark (Baldwin, C. Y., K. B. Clark. 2000. Design Rules: The Power of Modularity. MIT Press, Cambridge, MA), we implement a valuation approach using a numerical procedure based on the least-squares Monte Carlo method proposed by Longstaff and Schwartz (Longstaff, F. A., E. S. Schwartz. 2001. Valuing American options by simulation: A simple least-squares approach. Rev. Financial Stud. 14(1) 113-147). The approach is accurate, general, and flexible.

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File URL: http://dx.doi.org/10.1287/mnsc.1090.1070
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Bibliographic Info

Article provided by INFORMS in its journal Management Science.

Volume (Year): 55 (2009)
Issue (Month): 11 (November)
Pages: 1877-1896

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Handle: RePEc:inm:ormnsc:v:55:y:2009:i:11:p:1877-1896

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Related research

Keywords: real options; modularity; least-squares Monte Carlo;

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References

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  1. Andrea Gamba & Matteo Tesser, 2008. "Structural Estimation of Real Options Models," Working Papers wpn08-01, Warwick Business School, Finance Group.
  2. Gollier, Christian & Proult, David & Thais, Françoise & Walgenwitz, Gilles, 2004. "Choice of Nuclear Power Investments ander Price Uncertainty: Valuing Modularity," IDEI Working Papers 270, Institut d'Économie Industrielle (IDEI), Toulouse.
  3. Geske, Robert, 1979. "The valuation of compound options," Journal of Financial Economics, Elsevier, vol. 7(1), pages 63-81, March.
  4. Trigeorgis, Lenos, 1993. "The Nature of Option Interactions and the Valuation of Investments with Multiple Real Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(01), pages 1-20, March.
  5. Andrea Gamba & Leon Gordon & Carmen Aranda Leon, 2008. "Investment Under Uncertainty, Debt and Taxes," Working Papers wpn08-03, Warwick Business School, Finance Group.
  6. Lars Stentoft, 2004. "Convergence of the Least Squares Monte Carlo Approach to American Option Valuation," Management Science, INFORMS, vol. 50(9), pages 1193-1203, September.
  7. Carr, Peter P, 1988. " The Valuation of Sequential Exchange Opportunities," Journal of Finance, American Finance Association, vol. 43(5), pages 1235-56, December.
  8. Rodrigues, Artur & Armada, Manuel J. Rocha, 2007. "The valuation of modular projects: A real options approach to the value of splitting," Global Finance Journal, Elsevier, vol. 18(2), pages 205-227.
  9. Carliss Y. Baldwin & Kim B. Clark, 2000. "Design Rules, Volume 1: The Power of Modularity," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262024667, December.
  10. Broadie, Mark & Detemple, Jerome, 1996. "American Option Valuation: New Bounds, Approximations, and a Comparison of Existing Methods," Review of Financial Studies, Society for Financial Studies, vol. 9(4), pages 1211-50.
  11. Andrea Gamba & Lenos Trigeorgis, 2007. "An Improved Binomial Lattice Method for Multi-Dimensional Options," Applied Mathematical Finance, Taylor & Francis Journals, vol. 14(5), pages 453-475.
  12. Martzoukos, Spiros H. & Trigeorgis, Lenos, 2002. "Real (investment) options with multiple sources of rare events," European Journal of Operational Research, Elsevier, vol. 136(3), pages 696-706, February.
  13. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," University of California at Los Angeles, Anderson Graduate School of Management qt43n1k4jb, Anderson Graduate School of Management, UCLA.
  14. Paul A. Samuelson, 1973. "Proof That Properly Discounted Present Values of Assets Vibrate Randomly," Bell Journal of Economics, The RAND Corporation, vol. 4(2), pages 369-374, Autumn.
  15. Geske, Robert & Johnson, Herb E, 1984. " The American Put Option Valued Analytically," Journal of Finance, American Finance Association, vol. 39(5), pages 1511-24, December.
  16. Manuel Moreno & Javier Navas, 2003. "On the Robustness of Least-Squares Monte Carlo (LSM) for Pricing American Derivatives," Review of Derivatives Research, Springer, vol. 6(2), pages 107-128, May.
  17. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 113-47.
  18. Breen, Richard, 1991. "The Accelerated Binomial Option Pricing Model," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 26(02), pages 153-164, June.
  19. Andrea Gamba, 2002. "Real options Valuation: A Monte Carol Approach," Working Papers wpn02-02, Warwick Business School, Finance Group.
  20. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711, December.
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Citations

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Cited by:
  1. Daniel Gull, 2011. "Valuation of Discount Options in Software License Agreements," Business & Information Systems Engineering, Springer, vol. 3(4), pages 221-230, August.
  2. Jafarizadeh, Babak, 2012. "Information acquisition as an American option," Energy Economics, Elsevier, vol. 34(3), pages 807-816.
  3. Alexander Brauneis & Michael Loretz & Roland Mestel & Stefan Palan, 2011. "Inducing Low-Carbon Investment in the Electric Power Industry through a Price Floor for Emissions Trading," Working Papers 2011.74, Fondazione Eni Enrico Mattei.
  4. Rainer Andergassen & Luigi Sereno, 2012. "Valuation of N-stage Investments Under Jump-Diffusion Processes," Computational Economics, Society for Computational Economics, vol. 39(3), pages 289-313, March.

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