Real options with endogenous convenience yield

• Published date: 01 July 2019
• Author: Steven P. Clark,Yiying Cheng
• DOI: http://doi.org/10.1002/jcaf.22390
• Date: 01 July 2019

BLIND PEER REVIEW

Real options with endogenous convenience yield

Yiying Cheng

1

| Steven P. Clark

2

1

Cameron School of Business, University of

St. Thomas, Houston, Texas

2

Department of Finance, University of

North Carolina at Charlotte, Charlotte,

North Carolina

Correspondence

Yiying Cheng, Cameron School of Business,

University of St. Thomas, Houston, Texas.

Email: chengy@stthom.edu

Abstract

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.

KEYWORDS

endogenous convenience yield, real options, optimal investment timing

1|INTRODUCTION

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;30:30–43.wileyonlinelibrary.com/journal/jcaf