Real Option Valuation, Optimal Investment in the Pressence of Regime Switching & Mean Reverting Commodity Prices.

Abstract

This thesis investigates optimal investment in real options with the presence of regime switching and mean reverting commodity prices. Our aim is to provide a methodology that can address such behaviors in a commodity. Therefore, we are studying the electricity spot price as the underlying asset. In order to discover the value of the investment opportunity, we applied a combination of methods by utilizing a detailed algorithm. The algorithm accounts for early exercise values and is thus intended to value American real options. The analysis utilizes electricity price as the underlying variable on an investment in a hydropower plant. We find that electricity prices follow a mean reverting process with regime dependent parameters. Given this stochastic process, we analyze the optimal timing of an investment decision using a regime-augmented binomial tree. We illustrated the use of the algorithm on the hypothetical investment opportunity, where it provides us with the option value tree for the two volatility states as well as the optimal early exercise boundaries within each state. Our findings show that the algorithm is an efficient and easy way to value American real options with a mean-reverting underlying variable with multiple volatility states. It gives a fair option value and supplies early exercise boundaries for the option. The algorithm can easily be applied to time series with different characteristics and behaviours as well, with minor changes.