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Testing the Option Value Theory of Irreversible Investment

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  • Tarek M. Harchaoui

    (Statistics Canada)

  • Pierre Lasserre

    ()
    (Economics Department, UQAM)

Abstract

This paper statistically tests the option theory of irreversible investment under uncertainty. Using contingent claims valuation, we derive the value of options to invest in capacity, where the projects are endogenous to the economic circumstances prevailing at the investment date. We then test whether capacity investment decisions made by Canadian copper mines are compatible with the trigger price implied by the theory. The results speak strongly in favor of option theory as a theory of real investment. Our model explains both investment size and timing satisfactorily, from a statistical, and from an economic, point of view, and numerical simulations with a mean-reverting process suggest that the results do not depend crucially on the price being assumed to follow a geometric Brownian motion. Nous etablissons par la methode des actifs contingents la valeur de l'option d'effectuer des investissements irréversibles réels qui sont sensibles aux paramètres économiques prévalant au moment de la décision. Nous testons ensuite si des mines de cuivre canadiennes choisissent bien d'effectuer leurs investissements en capacité de production au moment où le prix du cuivre atteint le niveau critique impliqué par la théorie. Les résultats sont fortement en faveur de celle-ci. Le modèle explique tant la taille que la date des investissements, d'une manière statistiquement et économiquement satisfaisantes; des simulations avec un processus de retour à la moyenne indiquent que ces résultats ne dépendent pas de façon cruciale de l'hypothèse que le prix suit un processus brownien géométrique.

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Bibliographic Info

Paper provided by Université du Québec à Montréal, Département des sciences économiques in its series Cahiers de recherche du Département des sciences économiques, UQAM with number 9905.

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Length: 29
Date of creation: May 1999
Date of revision:
Publication status: published in the International Economic Review, Vol 42, No 1, February 2001, p. 141-166
Handle: RePEc:cre:uqamwp:9905

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Keywords: Irreversible Investment; Uncertainty; Contingent Claims; Option Value; Putty Clay; Real Investment; Trigger Price - Investissement irréversible; incertitude; actifs contingents; valeur d'option; investissement réel; prix critique;

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References

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  1. Robert J. Gordon, 1992. "Measuring the Aggregate Price Level: Implications For Economic Performance and Policy," NBER Working Papers 3969, National Bureau of Economic Research, Inc.
  2. George Koutoulas & Lawrence Kryzanowski, 1994. "Integration or Segmentation of the Canadian Stock Market: Evidence Based on the APT," Canadian Journal of Economics, Canadian Economics Association, vol. 27(2), pages 329-51, May.
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Cited by:
  1. Di Corato, Luca, 2010. "Profit Sharing under the Threat of Nationalization," Working Papers 58292, Swedish University of Agricultural Sciences, Department of Economics.
  2. Insley, M.C. & Wirjanto, T.S., 2010. "Contrasting two approaches in real options valuation: Contingent claims versus dynamic programming," Journal of Forest Economics, Elsevier, vol. 16(2), pages 157-176, April.
  3. Guo, Xin & Miao, Jianjun & Morellec, Erwan, 2005. "Irreversible investment with regime shifts," Journal of Economic Theory, Elsevier, vol. 122(1), pages 37-59, May.
  4. Enrico Pennings & Carlo Altomonte, 2006. "The Hazard Rate of Foreign Direct Investment: A Structural Estimation of a Real-option Model," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 68(5), pages 569-593, October.
  5. repec:hal:journl:halshs-00261523 is not listed on IDEAS
  6. Åsa Löfgren & Katrin Millock & Céline Nauges, 2008. "The Effect of Uncertainty on Pollution Abatement Investments: Measuring Hurdle Rates for Swedish Industry," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) halshs-00343702, HAL.
  7. Löfgren, Åsa & Millock, Katrin & Nauges, Céline, 2007. "Using Ex Post Data to Estimate the Hurdle Rate of Abatement Investments - An Application to the Swedish Pulp and Paper Industry and Energy Sector," Working Papers in Economics 249, University of Gothenburg, Department of Economics.
  8. Muehlenbachs, Lucija, 2012. "Testing for Avoidance of Environmental Obligations," Discussion Papers dp-12-12, Resources For the Future.
  9. repec:hal:journl:halshs-00272041 is not listed on IDEAS
  10. Guido Fioretti, 2002. "A Model of Primary and Secondary Waves in Investment Cycles," Microeconomics 0207014, EconWPA.
  11. Robert Cairns, 2004. "Green Accounting for an Externality, Pollution at a Mine," Environmental & Resource Economics, European Association of Environmental and Resource Economists, vol. 27(4), pages 409-427, April.
  12. repec:hal:journl:halshs-00343702 is not listed on IDEAS
  13. Sumru Altug & Fanny S. Demers & Michel Demers, 2004. "Tax Policy and Irreversible Investment," CDMA Working Paper Series 200404, Centre for Dynamic Macroeconomic Analysis.
  14. Turvey, Calum G. & Toole, Andrew A. & Kropp, Jaclyn D., 2007. "An Empirical Examination of the Relationship Between Real Options Values and the Rate of Investment," 2007 1st Forum, February 15-17, 2007, Innsbruck, Austria 6606, International European Forum on Innovation and System Dynamics in Food Networks.

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