Optimization of a Portfolio of Investment Projects: A Real Options Approach Using the Omega Measure

Javier G. Castro, Edison A. Tito and Luiz E. Brandão
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Javier G. Castro: Department of Production Engineering, Technology Center, Universidade Federal de Santa Catarina—UFSC, Florianópolis 88040-900, Brazil
Edison A. Tito: Department of Management, IAG Business School, Pontifical Catholic University of Rio de Janeiro—PUC-Rio, Rio de Janeiro 22451-045, Brazil
Luiz E. Brandão: Department of Management, IAG Business School, Pontifical Catholic University of Rio de Janeiro—PUC-Rio, Rio de Janeiro 22451-045, Brazil

JRFM, 2021, vol. 14, issue 11, 1-17

Abstract: Investment decisions usually involve the assessment of more than one financial asset or investment project (real asset). The most appropriate way to analyze the viability of a real asset is not to study it in isolation but as part of a portfolio with correlations between the input variables of the projects. This study proposes an optimization methodology for a portfolio of investment projects with real options based on maximizing the Omega performance measure. The classic portfolio optimization methodology uses the Sharpe ratio as the objective function, which is a function of the mean-variance of the returns of the portfolio distribution. The advantage of using Omega as an objective function is that it takes into account all moments of the portfolio’s distribution of returns or net present values (NPVs), not restricting the analysis to its mean and variance. We present an example to illustrate the proposed methodology, using the Monte Carlo simulation as the main tool due to its high flexibility in modeling uncertainties. The results show that the best risk-return ratio is obtained by optimizing the Omega measure.

Keywords: risk-return; real options; Monte Carlo simulation; portfolio optimization; Omega measure (search for similar items in EconPapers)
JEL-codes: C E F2 F3 G (search for similar items in EconPapers)
Date: 2021
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