Real options with endogenous convenience yield

Published date01 July 2019
Date01 July 2019
Real options with endogenous convenience yield
Yiying Cheng
| Steven P. Clark
Cameron School of Business, University of
St. Thomas, Houston, Texas
Department of Finance, University of
North Carolina at Charlotte, Charlotte,
North Carolina
Yiying Cheng, Cameron School of Business,
University of St. Thomas, Houston, Texas.
Traditional real options theory highlights the impact of risk on the timing of invest-
ment decisions. However, in practice, corporate projects often involve a prelimi-
nary exploratory stage, incurring a running cost and convenience yield. By analogy
with commodity futures theories, we model such multistage corporate projects in a
feedback-control framework, with a dynamic aggregate convenience yield/running
cost that interacts with the decisions to enter or exit the preliminary stage. We pro-
vide a closed-form solution for this compound options model. The solution pro-
vides insight and quantifies of the optimal strategy for prevalent corporate projects
with a preliminary exploration stage.
endogenous convenience yield, real options, optimal investment timing
After McDonald and Siegel (1986) and Dixit and Pindyck
(1994) established the real options approach to examining
optimal decision problems, real option models have been
widely applied in corporate finance to understand investment
valuation and timing under uncertainty. However, the applica-
tion of real options valuation has been limited in real-world
corporate decision making for several reasons. One of which,
as stated in the Block (2007) survey, is that real options
encourage excessive risk-taking because CFOs believe that it
overestimates the value of uncertain projects, encouraging
companies to inv est in them.Indeed, industrial projects
rarely start with a full investment at one decisionpoint. There-
fore, the overly simplistic model-setting of one stage and one
decision will invariably yield unrealistic optimal timing.
In this study, we present a real options model with a
preliminary stage in which the entry decision is partially
reversible and incurs a running cost and an endogenous con-
venience yield. This distinct additional stage models the
exploratory stage that precedes almost all industrial projects.
Our model displays the interaction between the optimal
investment decision and the convenience yield as well as the
running cost incurred in this preliminary stage. This
framework therefore provides a potential reconciliation
between the traditional real option theory predictions and
industrial practice.
In our model, the convenience yield and the running cost
are two key factors that differentiate the preliminary stage
and the final investment stage. The convenience yield is the
monetary yield or the intangible convenience that is realized
only when holding the end-product of a project; while the
running cost is the ongoing cost incurred during the prelimi-
nary stage. By analogy to commodity futures pricing theo-
ries, investors give up the convenience yield or the running
cost by holding open the option to invest instead of exercis-
ing the option to commence the project.
In practice, the preliminary stages of corporate invest-
ment projects almost always incur a running cost. In theory,
however, to motivate a company to enter such a preliminary
stage instead of reducing to one stage investment, there must
be an offsetting effect in the convenience yield. Therefore,
we assume that the overall running cost not only depends on
the investment timing, but also interacts with the conve-
nience yield. In particular, a higher running cost could par-
tially offset the convenience yield that is forfeited by
holding the option open instead of exercising and investing.
In commodity futures market, the impact of running cost and
Received: 26 March 2019 Accepted: 4 April 2019
DOI: 10.1002/jcaf.22390
30 © 2019 Wiley Periodicals, Inc. J Corp Acct Fin. 2019;

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