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Investment Research report
Investment Research Report
By: Syed Imran Raza
For: International Research Association
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In prinipl, RO offrs potntil dvntgs ovr
trditionl nt prsnt vlu (NPV) nd disountd sh flow
(DF) pprohs, both of whih my ld to undr-invstmnt in
high-risk rs. It pls positiv vlu on risk by
xploiting th opportunity to phs invstmnts nd stg ky
disions so s to (i) llow trmintion of initil xplortory
R&D projts whih turn out to b unsussful, nd (ii) invst
mor in thos showing positiv futur prospts. By ontrst,
NPV nd DF viw risk ngtivly nd, by ignoring th option
pproh, impos highr disount rts to djust for highr
risk, thus rduing th vlu of futur xptd inom strms.
Th intuition bhind this potntil outom is s follows.
Trditionl invstmnt pprisl thniqus n b onivd s
bing onrnd with on-shot vlution of n invstmnt in n
sst. Th initil invstmnt is followd by sris of
(oftn) unrtin sh flows ovr tim. DF nlysis is th
industry stndrd vlution thniqu. It tks ount of th
tim-vlu of mony through th us of risk fr intrst
rt, nd of riskinss by dding risk prmium to th risk
fr rt in disounting futur sk flows.
This pproh nglts th insight whih riss from
rognising th phsd ntur of mny invstmnt disions,
whih my bgin with xplortory phss bfor finl sst
invtsmnt disions r md. Mny invstmnt projts hv in
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fft n options phs prior to th sst phs. During th
options phs, invstmnts r not bing md in n sst to
gnrt strm of sh flows but to stblish th opportunity
(but not th obligtion) to subsquntly invst in suh n
sst. Th invstmnt in R&D is fftivly n options - i n
xplortory - phs, whih is th nssry prursor in ordr
to llow futur invstmnt in th finl sst phs whih in
this s is th futur ommriliztion projt if th R&D is
susful.
NPV thniqus r inpproprit to vlu projts in
options phss, suh s R&D invstmnt, bus first thy do
not tk into ount th vlu of th option phs, nd sond
thy nglt th ft tht ommitmnts to futur invstmnts r
ontingnt on how th futur unfolds. In th s of R&D thy
will b ontingnt on thnil suss s wll s mrkt or
politil irumstns. Th bility to bndon projt - i
not xris th option for furthr invstmnt - mns tht
downsid risk n b rdud to th initil invstmnt whn
things go wrong. If irumstns r fvourbl, howvr, th
full upsid bnfit n b pturd. This ssymmtry gnrts
th rl options vlu. Th ttnds r listd t nnx 2.
Illustrtiv xmpl of Rl Options nysis
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Suppos n R&D projt rquirs n outly of 3m now to
nbl th invsmnt of 80m in nw produt ftr sussful
R&D. Suppos furthr tht th rtin vlu of th sh flow
from this sst is 100m.
If th R&D is blivd to hv 10% hn of suss,
stndrd vlution, tking into ount th thnil
unrtinty in th R&D ssigns to this projt vlu of
10% x (100m 80m) - 3m = minus 1m.
On this bsis it dos not sm to b worth doing.
Rl options rsoning howvr rogniss tht if th R&D
wr sussful, it would giv n option to invst th 80m in
nw produt, but rognizs thr is no obligtion to do so.
Suppos thr is 50% hn of fvourbl rgultion
rsulting in n stimtd sh flow from th nw produt of
160m. This is offst by 50% hn of n unfvourbl
rgultion, rsulting in vlu of th sh flow of only 40m.
Th vrg or xptd vlu of th sh flow is 100m, just
s in th s whr thr ws no unrtinty (Blk, F.,
Shols, M. 1973 pp.637-640).
In th unfvourbl s thr will b no furthr
invstmnt - invsting 80m for rturn of 40m mks no sns.
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So th projt will b bndond kping th downsid t th
sunk ost of 3m.
In th fvourbl s, th invstmnt will our nd thn
th vlu of th invstmnt will b 160m minus 80m or 80m.
Sin thr is 50% hn of fvourbl rgultion, w
thrfor xpt vlu of 0.5 x 80m or 40m in th sst
phs of th projt. Tking ount of th ft tht thr is
only 10% hn of sussful R&D, nd tking ount of th
sunk ost of 3m initil invstmnt w rriv t vlu of 0.1
x (40m) 3m = plus 1m.
Thus by introduing grtr unrtinty - i mor rlity
givn tht thr is usully mor thn on possibl outom - w
hv movd from ngtiv projt vlu of minus 1m to
positiv vlu of plus 1m.
If th unrtinty in th sst phs is furthr inrsd,
for xmpl if in th upsid snrio th produt is worth
200m, but in th downsid it nnot b lunhd t ll nd is
worth zro, thn w still hv n vrg vlu of 100m in th
invstmnt phs.
But now th vlu ftr rl options rsoning is 0.1 x 0.5
x (200m 80m) - 3m = plus 3m. In othr words, th inrsd
unrtinty hs givn th projt highr vlu this is quit
diffrnt to n NPV nlysis, whr n inrsd unrtinty
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would b djustd for by highr disount rt, rsulting in
lowr vlu of th projt.
RO modlling is wll dvlopd in finnil mrkts -
whih hv sophistitd nd wll dvlopd mthods of priing
risk nd wll dvlopd thory justifying th us of thos
pris. Howvr thr r onptul nd mpiril problms to
b ovrom in using th thniqu to obtin quntittiv
vlutions in rl sst invstmnt dision-tking.
Nvrthlss thr r xmpls of th us of RO in mking suh
invstmnt disions, prtiulrly in th phrmutils nd
tlommunitions industris . RO hs lso bn usd s prt
of th Forsight projt on xploiting th ltromgnti
sptrum .
Th ntrl qustion, whih th Workshop onsidrd, ws
whthr RO ould b usd to hlp th DTIs Thnology Strtgy
Bord (TSB) in mking finnil llotions btwn diffring
thnologis, nd lso btwn diffrnt projts within
prtiulr thnologis. Th Workshop lso onsidrd brifly
whthr RO ould b pplid to thos invstmnts by Govrnmnt
whih ly furthr upstrm, in prtiulr to th grnts md by
th Rsrh ounils to univrsitis to support strtgi
rsrh. Ths unrtintis dd diffiultis to th vlution
pross of th finnil vibility of th projt, spilly
givn long onssion priods (Ho nd Liu, 2002). Thy n ply
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signifint rol in th totl vlu of th projt; for
instn, givn n unrtinty in dmnd, thr is potntil
for th projt to hv dditionl vlu if th dmnd
inrss. Howvr, thr is lso potntil for rdution in
th vlu of th projt if th dmnd drss.
Ths unrtintis r onsidrd s dynmi
unrtintis. ording to Ford t l. (2002), dynmi rfrs
to th volution ovr tim of th unrtin onditions, or th
prption of thos onditions, tht dtrmin th optiml
strtgy for th prty riving th bnfits nd bsorbing th
osts of tht unrtinty. In th s of wtr infrstrutur
systms, th dynmi unrtintis r rltd to, mong othr
spts, th dtriortion of th infrstrutur omponnts
(min pips, vlvs, wtr pumps). If ths omponnts
dtriort t highr rt, omprd to th ssumption md t
th bidding tim, th privt invstor hs to llot mor
rsours to mintin th oprtion of th wtr ntwork. Th
rturn on invstmnt my onsquntly drs givn ths
pitl invstmnts. (Bitti, ., Rymond, P. 2005, Pp. 56-59)
Trditionlly, risk mngmnt strtgis suh s
mitigtion, divrsifition, nd limintion hv fousd on th
ngtiv impt of th dynmi unrtintis. For instn, in
ordr to rdu th risk of dditionl osts for n importnt
mintnn tivity, th privt oprtor of th wtr systm
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my fix th vlu of th mintnn srvi with
subontrtor, whih mns tht ny futur hng in th pris
of mtrils, lbor, nd quipmnt will b ssumd by th
subontrtor. Obviously, this strtgy prvnts dditionl
osts to th gnrl ontrtor, but it lso limits th
opportunitis for ost rdution if th mrkt pris of
mtrils drs t th ommnmnt of th mintnn
tivitis. Givn th dynmi bhvior of th unrtintis,
(ost rdution ovr tim, nw thnologis, omptition btwn
subontrtors, nw mtrils) thr is positiv point of viw
tht should b tkn into ount during th vlution of th
projt. For xmpl, nw thnologis nd mtrils my hlp to
mintin th infrstrutur for longr priod of tim t th
sm ost. In ordr to ssss th dynmis of th unrtinty
nd its impt on th vlu of th projt, it is nssry to
pproh th pitl invstmnt problm with nw mthodologis
tht hv bn pplid sussfully in othr domins, suh s
th finnil mrkts, sin trditionl mthodologis suh s
disountd sh flow do not ount for flxibl mngril
strtgis by th privt invstor. On of ths novl
mthodologis is rl options nlysis (RO).
ording to D Nufvill (2004), th dvlopmnt of RO
holds th promis of nbling th nginring profssion to
lult th vlu of flxibility. Hr, th onpt of
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flxibility rfrs to th bility of th projt mngrs to
mk hngs in th oprtionl strtgis of th filitis
bsd on th urrnt onditions of th infrstrutur systms.
Ths onditions my b diffrnt whn omprd to th
onditions ssumd during th bidding pross.
Utilizing PPP for wtr nd wstwtr systms rquirs
dtild vlution of th projt sh flow. s prt of this
vlution pross, it is nssry to onsidr th xptd
rvnus nd osts. n importnt lmnt of th ost stimtion
is ssssmnt of th dtriortion pross of th diffrnt
infrstrutur omponnts. Bsd on this ssssmnt, th privt
prtnr n stimt th rsours (pitl invstmnts)
rquird to oprt nd mintin th infrstrutur systm
throughout th onssion priod without ompromising th
qulity of srvi. Dtriortion modls r nssry to
dtrmin th projt's pitl invstmnts bus th
dtrmintion of ost-fftiv mintnn tions rquirs
informtion bout its urrnt ondition, s wll s th
ntiiptd futur onditions of th infrstrutur's omponnts
(Wirhdikusumh, 1999).
Stohsti prosss hv bn usd to modl th
dtriortion pross of infrstrutur systms (Rmswmy nd
Bn-kiv, 1990; Morous t l., 2002). ommon stohsti
pross usd is th Mrkov hins mthodology, whih ssums
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tht th ondition of th infrstrutur t tim t+1 dpnds on
th ondition t tim t nd dos not dpnd on th stts th
hin pssd through until tim t (Winston, 2004). Givn tht
th futur ondition of n infrstrutur systm is unrtin,
it is possibl to onsidr tht this unrtinty my provid
flxibl mintnn strtgis to th oprtor of th
infrstrutur (privt prtnr), givn tht th rl
ondition t tim t is urrntly unknown but will b known in
th futur (i.. t t+1). Thrfor, thr is vlu in witing
until th ondition of th infrstrutur omponnt is known to
dtrmin th mount of th pitl invstmnt rquird to
mintin th oprtion of th infrstrutur. If th ownr of
th infrstrutur (publi prtnr) is bl to stimt th
vlu of unrtinty (flxibility), it is possibl to xpt
highr bidding pris from th privt invstors intrstd in
th oprtion nd mintnn of n xisting infrstrutur
systm. This hppns bus th totl mrkt vlu of th
projt is th sum of two omponnts:
1. Vlu without flxibl ltrntivs (fixd mintnn
poliy); nd
2. Th vlu of th mngril options.
Th mthodology proposd in this ppr uss Mrkov hins
trnsition probbilitis s msur of th systm's
unrtinty nd is rprsntd by th dtriortion urvs of
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th infrstrutur omponnts. This unrtinty is onsidrd in
th RO in ordr to stimt n urt vlu of th projt.
In this ppr, th nlysis nd vlution of th flxibility of
th pitl invstmnts rquird to mintin th oprtion of
th infrstrutur systm will b ssssd from th ownr's
prsptiv. Howvr, similr produrs n b pplid by th
projt's potntil invstor. In ordr to obtin n urt
projt vlu, it is nssry to xpnd th onpt of disount
sh flows nd to ount for th vlu of th flxibility
(unrtinty) in th xisting infrstrutur systms.
mthodology tht hs bn usd to vlu flxibility in pitl
invstmnts is rl options nlysis (RO). vn though th
onpt is not nw (Lunbrgr, 1998), its pplition in th
vlution of pitl invstmnts is rnt (Ho nd Liu, 2002;
Ford t l., 2002; Yo nd Jfri, 2003; Grvin nd hh,
2004; oplnd nd Tufno, 2004; Vn Puttn nd MMilln, 2004).
ording to Ross t l. (2002), n option is ontrt giving
its ownr th right to buy or sll n sst t fixd pri on
or bfor givn dt, whih mns tht it is possibl t tim
t+1, givn nw informtion olltd in th tim priod btwn
t nd t+1, to mk bttr dision bsd on th urrnt vlu
of th sst t tim t+1. For instn, if th futur pri of
n importnt onstrution mtril in projt is unrtin,
ontrtor my py prmium to supplir in ordr to hv th
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option of buying givn mount of mtrils t pri
(xris pri) dtrmind tody (tim t). Dpnding on th
mrkt ondition t tim t+1, th ontrtor will hv th
flxibility of diding whih pri is th most onvnint. If
th mrkt pri is highr thn th xris pri, th
ontrtor will buy th mtrils t th xris pri, sving
mony omprd to th urrnt mrkt pri. If th mrkt pri
is lowr thn th xris pri, th ontrtor will not us
his option nd h will buy th mtrils t th mrkt pri.
Th originl prmium is not rovrd in ny s. This simpl
xmpl illustrts tht th onpt of rl options n ptur
th flxibility of mngmnt disions undr unrtinty.
Th privt oprtor of th infrstrutur systms mks pitl
invstmnt disions (rstortion, mintnn, nd oprtion)
bsd on th sttus of th infrstrutur throughout th
projt's lif. This dt is olltd from th thnil
vlution (on-sit insption) of th urrnt onditions of th
diffrnt omponnts. So, th privt invstor is mking
disions bsd on xisting dt (no unrtinty) during th
oprtion of th infrstrutur. Howvr, th originl bid ws
prprd bsd on ssumptions (forsting) of th sttus of th
infrstrutur x yrs from th dt of th bid submission. t
th tim of th bid submission, thr ws unrtinty, but whn
th pitl invstmnt disions r md, this unrtinty no
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longr xists bus urrnt ondition dt of th
infrstrutur omponnts boms vilbl. Trditionl DF
mthodologis r unbl to ptur th unrtinty in th
ondition of th infrstrutur systms, nd th nlyst t most
my rt snrios to rprsnt diffrnt infrstrutur
onditions. Ths snrios sk to rprsnt th rng of
possibl outoms in simpl, trtbl mnnr. In gnrl,
thr r thr snrios:
1. Bst s;
2. Bs s; nd
3. Worst s.
nothr mthodology tht n b usd to stimt th vlu of
th option is pplying ontinuous-tim modl (Lunbrgr,
1998; Grvin nd hh, 2004). This mthodology rquirs
thorough undrstnding of diffrntil lulus to solv th
diffrntil qution (gomtri Brownin motion) tht dsribs
th bhvior of th undrlying sst. numril produr tht
is lso usd to vlu options is th binomil mthod, nd this
mthod is sir to dpt to th vlution of rl options
omprd to th Blk-Shols modl or th ontinuous tim
modl. Th binomil mthod uss binomil trs to pproximt
th bhvior of th undrlying sst, ssuming tht th
invstors r risk-nutrl. In this s, it is ssumd tht th
invstors dmnd no dditionl ompnstion byond th risk-fr
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rt, rgrdlss of th risk of th sst in qustion (Ross t
l., 2002). Th binomil trs ssum tht ovr singl priod,
th undrlying sst pri n mov from its urrnt pri to
on of two possibl lvls: up or down. This movmnt is rltd
to th voltility of th undrlying sst.
On of th bnfits of RO in PPPs is th pprition of
th diffrnt ltrntivs ssoitd with th projt. For
instn, th publi ntity my did to postpon th
ommnmnt of th projt in ordr to gthr bttr
informtion rgrding th dtriortion pross of th
infrstrutur systms or to dtrmin th vribility of th
projt's dmnd. It is nssry to ontmplt wht typs of
options xist (dfr, bndon, swith) in th projt, how ths
options n b rtd, how thy dd vlu to th projt, nd
how th mngmnt tm n tk dvntg of th unrtinty
involvd in th projt. This dos not mn tht trditionl
mthods should b ignord, rthr tht RO provids dditionl
tools to do bttr ssssmnt of th onomi bnfits of th
projt.
onlusions
t prsnt, th prinipl vlu of RO s n id to
Govrnmnt invstmnt disions ws likly to b in dtrmining
th qulittiv pross to nbl nlysts to look t
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prtiulr invstmnt opportunity nd brk it down into its
omponnt stgs. Using RO s qulittiv disiplin nd
dopting n xpliitly phsd pproh ws vry vlubl in
stimulting thinking bout th rng of invstmnt options
vilbl, how ths might hng with tim, whr th
invstmnt ut-off points wr, wht th probbility of suss
of h option t h stg in th pross might b, nd s
lrning mhnism for futur disions. RO ws t rltivly
rly stg of dvlopmnt s quntittiv nlytil tool for
publi stor dision-mking, omprd with othr thniqus
suh s NPV nd DF. Morovr thr ws som unrtinty s to
th xtnt to whih it ws usd in th privt stor nd th
rsons for its pprntly pthy doption. Thr ws, howvr,
n tiv intrntionl dmi nd prtitionr rsrh
intrst in its dvlopmnt nd pplition nd som mjor
ompnis wr vluting its potntil. Mor dvlopmnt work
on RO would b ndd bfor it ould b pplid quntittivly
in publi stor ontxt to th sort of disions tht th TSB
wr mking bout th lvl of invstmnt in prtiulr ky
thnologis. In prtiulr, it ws urrntly not wll suitd t
prsnt to dtrmining invstmnt lvls t high lvl of
gnrlity, for xmpl invstmnt in imging thnologis vs
nrgy thnologis, or mission to Mrs vs stm ll rsrh.
It ws lso snsitiv to th ft tht th diffrnt stgs in
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limitd th pplition of RO to invstmnt disions in
diffrnt projts within prtiulr thnology r, lthough
hr ths ffts wr likly to b lss signifint.
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