Numerical Analysis

In the previous chapter, a general model formulation for portfolios of real options has been proposed. This model provides a framework that incorporates the identified specific aspects of portfolios of real options and thus helps to optimally manage portfolios of real options. Up to this point, we have provided a general valuation structure but have not yet shed any light on the structural properties of such portfolios. This is why in this section we will exploit the impact of the main drivers of portfolio value and their impact on the optimal investment strategy.

Keys drivers of the value of portfolios of real options are budget effects, volatility effects, correlation effects, and starting value effects. Embracing all of these effects are path–dependencies which simultaneously result from the interdependency of the budget constraint and of option exercise decisions. It will be shown that these value drivers can cause investment strategies that are puzzling in the first place, e.g., they imply shutting down an asset that is profitable. Nevertheless, the optimal investment strategy can be related, with more thorough analysis, to financial intuition and prior work on complex financial options. As to be expected, these drivers affect portfolio value in a complex way. Budget constraints establish sub–additivity of options value and may require to move in and out of assets in order to realize the highest value. This can cause disinvestment decisions that from a naïve point of view seem to be value destroying but which make it possible to undertake or help finance even more profitable investments for different assets and later periods with a positive net effect on portfolio value. Closely connected to budget effects are volatility effects. A basic understanding from standard option pricing would justify expecting options portfolio values to increase in the volatility of the underlying assets. For portfolios of real options, the impact of increasing volatility may be reversed. Typically, options benefit from higher volatility because they allow to capitalize on the upside while protecting from the downside of an increased variability in the out comes. This may not materialize when the interplay of volatility and budget constraints prevents from capitalizing on the upside. Correlation and starting values can cause different effects, depending on the structure of the investment problem. Intuitively, the encountered effects can be attributed to the net character of the investment problem, i.e., whether it tends to be an investment problem with some disinvestment options or the other way round.