Technical Uncertainty in Real Options with Learning

20 Pages Posted: 6 Oct 2014 Last revised: 24 Jun 2017

See all articles by Ali Al-Aradi

Ali Al-Aradi

University of Toronto - Department of Statistics

Álvaro Cartea

University of Oxford; University of Oxford - Oxford-Man Institute of Quantitative Finance

Sebastian Jaimungal

University of Toronto - Department of Statistics

Date Written: June 23, 2017

Abstract

We introduce a new approach to incorporate uncertainty into the decision to invest in a commodity reserve. The investment is an irreversible one-off capital expenditure, after which the investor receives a stream of cashflow from extracting the commodity and selling it on the spot market. The investor is exposed to price uncertainty and uncertainty in the amount of available resources in the reserves (i.e. technical uncertainty). She does, however, learn about the reserve levels through time, which is a key determinant in the decision to invest. To model the reserve level uncertainty and how she learns about the estimates of the commodity in the reserve, we adopt a continuous-time Markov chain model to value the option to invest in the reserve and investigate the value that learning has prior to investment.

Keywords: Real Options, Irreversible Investment, Technical Uncertainty, Learning

Suggested Citation

Al-Aradi, Ali and Cartea, Álvaro and Jaimungal, Sebastian, Technical Uncertainty in Real Options with Learning (June 23, 2017). Available at SSRN: https://ssrn.com/abstract=2505444 or http://dx.doi.org/10.2139/ssrn.2505444

Ali Al-Aradi

University of Toronto - Department of Statistics ( email )

100 St. George St.
Toronto, Ontario M5S 3G3
Canada

Álvaro Cartea

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

Eagle House
Walton Well Road
Oxford, Oxfordshire OX2 6ED
United Kingdom

Sebastian Jaimungal (Contact Author)

University of Toronto - Department of Statistics ( email )

100 St. George St.
Toronto, Ontario M5S 3G3
Canada

HOME PAGE: http://www.utstat.utoronto.ca/sjaimung

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