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Technical Uncertainty in Real Options with Learning

Ali Al-Aradi, Alvaro Cartea and Sebastian Jaimungal

Papers from arXiv.org

Abstract: We introduce a new approach to incorporate uncertainty into the decision to invest in a commodity reserve. The investment is an irreversible one-off capital expenditure, after which the investor receives a stream of cashflow from extracting the commodity and selling it on the spot market. The investor is exposed to price uncertainty and uncertainty in the amount of available resources in the reserves (i.e. technical uncertainty). She does, however, learn about the reserve levels through time, which is a key determinant in the decision to invest. To model the reserve level uncertainty and how she learns about the estimates of the commodity in the reserve, we adopt a continuous-time Markov chain model to value the option to invest in the reserve and investigate the value that learning has prior to investment.

Date: 2018-03, Revised 2018-07
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