Real option pricing of network design investments

Joseph Ying Jun Chow, Amelia C. Regan

Research output: Contribution to journalArticle

Abstract

Areal option solution and method are used to quantify the value of flexibility for deferral and design strategies in investments made in a network. The model is proposed to address managerial flexibility in transportation planning and can be applied to any network design problem under uncertainty. The core framework is based on the assumption that some variable such as travel demand can be characterized by nonstationary, multi-dimensional stochastic processes, such as geometric Brownian motion. By exploiting that characterization, it is possible to determine the value of the flexibility to defer the investment or to redesign the network by solving a dynamic program with network design subproblem using a least squares Monte Carlo simulation algorithm. The option premium is shown to decompose into a basic deferral premium and a flexible network design premium, which quantifies the cost of committing to preferred alternative in transportation planning. The proposed model is tested on the classic Sioux Falls, South Dakota, network, showing that a traditional discounted cash-flow analysis may support an immediate investment of a continuous network design but that under some conditions, deferral with the option to redesign can offer the greatest option value.

Original languageEnglish (US)
Pages (from-to)50-63
Number of pages14
JournalTransportation Science
Volume45
Issue number1
DOIs
StatePublished - Feb 2011

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pricing
premium
Costs
flexibility
Planning
Brownian movement
Random processes
Values
planning
travel
uncertainty
simulation
demand
costs

Keywords

  • Flexible design
  • Network design
  • Real options

ASJC Scopus subject areas

  • Transportation

Cite this

Real option pricing of network design investments. / Chow, Joseph Ying Jun; Regan, Amelia C.

In: Transportation Science, Vol. 45, No. 1, 02.2011, p. 50-63.

Research output: Contribution to journalArticle

Chow, Joseph Ying Jun ; Regan, Amelia C. / Real option pricing of network design investments. In: Transportation Science. 2011 ; Vol. 45, No. 1. pp. 50-63.
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