Real options valuation. The importance of interest rate modelling in theory and practice. With a foreword by Stewart C. Myers and Ulrich Hommel. (Q2571101)

This thesis analyzes real options in the context of a stochastic interest rate. Traditional Discounted Cash Flow (DCF) methods have been used in corporate finance to evaluate, in a deterministic context, the desirability of an investment project. These methods glossed over the uncertainty associated with such projects and ignored the typical branching options available to the investors, such as abandonment/expansion after adverse/favourable information comes to light. The insight of real option theory was to recognise that the stochastic cash flow, generated by a typical project, could be modelled as an option along the line of the Black-Scholes analysis. For instance, the option to abandon a project is isomorphic to a put-option to sell the investment for its salvage value. Fixed interest bonds, and by extension and fixed-interest bearing security, carries an interest rate risk. That is, the price of the security over its lifetime will fall and rise in opposite direction to the current interest rate. It is well known that an option can be replicated by a combination of buying/selling short its underlying asset and a bond. It follows that the value of an option is affected by the interest rate risk. To put it differently, the value of a \$ 100 cash flow in few years time depends on how the interest rate will behave during that time. Although this interest rate risk is well known in corporate finance, it has been only marginally addressed by the real option literature. This thesis undertakes a number of numerical simulations to calculate the value of complex real option rights in the context of stochastic interest rates. It evaluates different valuation methods against historical datasets and compares their results with the predictions of the standard constant interest rate methods. One finding is of the importance of adjusting for the shape of the term structure. That is, at any one time, bonds are traded with different maturities. The interest rate on, say, a bond with 3-month maturity is typically different from the one a 20-year maturity, even if issued by the same borrower. The correspondence between the maturity of the bond and the associated interest rate is called the term structure. Typically, a longer maturity bond incorporate both an interest rate risk and some expectation of what the interest rate will do over time. Hence, the term structure contains some information on the expectations of the agents about future interest rates, the implicit forward interest rates underlying the agents trades in the bond market. The author finds that the use of implicit forward rates is preferable to the use of constant interest rates. This thesis analyses the value of real options to abandon/expand or to delay an investment project. It analyses various scenarios for the Vasiček, Cox-Ingersoll-Ross, Hull-White and Ho-Lee models of term structure. It also provides an introduction to and a literature review for real options and term structure.