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The application of real option analysis on a gas-to-wire investment scenario

Heeswijk, W.J.A. van (2012) The application of real option analysis on a gas-to-wire investment scenario.

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Abstract:With this study, we aim to increase understanding of the insights that real option analysis (ROA) has to offer, particularly in comparison to dynamic decision tree analysis (DTA). We point out the fundamental theoretical shortcoming of applying a constant discount rate in the latter approach, and explain how real options resolve this issue. Based on the fundaments of risk-neutral valuation and replicating portfolio concepts, we address different perspectives on how to treat non-hedgeable risks in a real option framework. We adopt an integrated view combining option pricing and decision analysis, which is theoretically consistent and allows an assessment of both market risk and private risk. To illustrate the practical application of real option analysis, we construct a model which determines the optimal time to switch from gas production to electricity generation directly at the wellhead (Gas-to-Wire). To deal with the path-dependent price paths in this investment problem, we use a combination of Monte Carlo simulation and a backwards regression algorithm. We construct forecasting models for natural gas and electricity prices. These models deal with the seasonal effects, price jumps, mean-reversion and time-varying volatility observed particularly in electricity prices. With a comparative study, we show that ROA provides results that significantly deviate from those yielded by DTA.
Item Type:Essay (Master)
Faculty:BMS: Behavioural, Management and Social Sciences
Subject:85 business administration, organizational science
Programme:Industrial Engineering and Management MSc (60029)
Link to this item:http://purl.utwente.nl/essays/62536
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