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Testing the Option Vakue Theory of Irreversible Investment

Author

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  • Harchaoui, T.
  • Lasserre, P.

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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Suggested Citation

  • Harchaoui, T. & Lasserre, P., 1995. "Testing the Option Vakue Theory of Irreversible Investment," G.R.E.Q.A.M. 95b04, Universite Aix-Marseille III.
  • Handle: RePEc:fth:aixmeq:95b04
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    References listed on IDEAS

    as
    1. Gordon, Robert J, 1992. "Measuring the Aggregate Price Level: Implications for Economic Performance and Policy," CEPR Discussion Papers 663, C.E.P.R. Discussion Papers.
    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 329-351, May.
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    Citations

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    Cited by:

    1. 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.
    2. Jérôme Bourdieu & Benoît Coeuré & Béatrice Sédillot, 1997. "Investissement, incertitude et irréversibilité. Quelques développements récents de la théorie de l'investissement," Revue Économique, Programme National Persée, vol. 48(1), pages 23-53.
    3. Sumru Altug & Fanny S. Demers & Michel Demers, 2004. "Tax Policy and Irreversible Investment," CDMA Working Paper Series 200404, Centre for Dynamic Macroeconomic Analysis.
    4. Löfgren, Åsa & Millock, Katrin & Nauges, Céline, 2008. "The effect of uncertainty on pollution abatement investments: Measuring hurdle rates for Swedish industry," Resource and Energy Economics, Elsevier, vol. 30(4), pages 475-491, December.
    5. 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.
    6. Di Corato, Luca, 2013. "Profit sharing under the threat of nationalization," Resource and Energy Economics, Elsevier, vol. 35(3), pages 295-315.
    7. repec:hal:journl:halshs-00343702 is not listed on IDEAS
    8. Guido Fioretti, 2005. "A Model of Primary and Secondary Waves in Investment Cycles," Computational Economics, Springer;Society for Computational Economics, vol. 24(4), pages 357-381, June.
    9. 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.
    10. Muehlenbachs, Lucija, 2012. "Testing for Avoidance of Environmental Obligations," Discussion Papers dp-12-12, Resources For the Future.
    11. El-Shazly Alaa, 2004. "Investment Under Uncertainty in Egypt: A Real-Options Approach," Review of Middle East Economics and Finance, De Gruyter, vol. 2(2), pages 51-60, August.
    12. repec:eee:reveco:v:49:y:2017:i:c:p:596-611 is not listed on IDEAS
    13. repec:hal:journl:halshs-00261523 is not listed on IDEAS
    14. Slade, Margaret E., 2015. "The rise and fall of an industry: Entry in U.S. copper mining, 1835–1986," Resource and Energy Economics, Elsevier, vol. 42(C), pages 141-169.
    15. Robert Cairns, 2004. "Green Accounting for an Externality, Pollution at a Mine," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 27(4), pages 409-427, April.
    16. 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.
    17. Guo, Xin & Miao, Jianjun & Morellec, Erwan, 2005. "Irreversible investment with regime shifts," Journal of Economic Theory, Elsevier, vol. 122(1), pages 37-59, May.
    18. Marmer, Vadim & Slade, Margaret, 2016. "Investment and Uncertainty With Time to Build: Evidence from U.S. Copper Mining," Microeconomics.ca working papers vadim_marmer-2016-14, Vancouver School of Economics, revised 22 Dec 2016.

    More about this item

    Keywords

    DYNAMIC PROGRAMMING; INVESTMENTS;

    JEL classification:

    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • G1 - Financial Economics - - General Financial Markets
    • L72 - Industrial Organization - - Industry Studies: Primary Products and Construction - - - Mining, Extraction, and Refining: Other Nonrenewable Resources
    • Q31 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Nonrenewable Resources and Conservation - - - Demand and Supply; Prices

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