Real Options using Markov Chains: an application to Production Capacity Decisions

Dalila B. M. M. Fontes (), Luís Camões () and Fernando A. C. C. Fontes ()
Additional contact information
Dalila B. M. M. Fontes: LIAAD and Faculdade de Economia da Universidade do Porto, Portugal
Luís Camões: Banif -- Banco Internacional do Funchal
Fernando A. C. C. Fontes: Departamento de Matemática para a Ciência e Tecnologia, Universidade do Minho

FEP Working Papers from Universidade do Porto, Faculdade de Economia do Porto

Abstract: In this work we address investment decisions using real options. A standard numerical approach for valuing real options is dynamic programming. The basic idea is to establish a discrete-valued lattice of possible future values of the underlying stochastic variable (demand in our case). For most approaches in the literature, the stochastic variable is assumed normally distributed and then approximated by a binomial distribution, resulting in a binomial lattice. In this work, we investigate the use of a sparse Markov chain to model such variable. The Markov approach is expected to perform better since it does not assume any type of distribution for the demand variation, the probability of a variation on the demand value is dependent on the current demand value and thus, no longer constant, and it generalizes the binomial lattice since the latter can be modelled as a Markov chain. We developed a stochastic dynamic programming model that has been implemented both on binomial and Markov models. A numerical example of a production capacity choice problem has been solved and the results obtained show that the investment decisions are different and, as expected the Markov chain approach leads to a better investment policy.

Keywords: Flexible Capacity Investments; Real Options; Markov Chains; Dynamic Programming (search for similar items in EconPapers)
JEL-codes: C61 G31 (search for similar items in EconPapers)
Pages: 17 pages
Date: 2007-07
New Economics Papers: this item is included in nep-cmp
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
http://www.fep.up.pt/investigacao/workingpapers/07 ... _FontesCamFontes.pdf (application/pdf)
Our link check indicates that this URL is bad, the error code is: 404 Not Found (http://www.fep.up.pt/investigacao/workingpapers/07.07.30_wp246_FontesCamFontes.pdf [302 Found]--> https://fep.up.pt/investigacao/workingpapers/07.07.30_wp246_FontesCamFontes.pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:por:fepwps:246

Access Statistics for this paper

More papers in FEP Working Papers from Universidade do Porto, Faculdade de Economia do Porto Contact information at EDIRC.
Bibliographic data for series maintained by ().