Real Option Pricing of Network Design Investments

Authors:
Joseph Y. J. Chow;Amelia C. Regan
Affiliations:
Institute of Transportation Studies, University of California, Irvine, Irvine, California 92697;Department of Computer Science and Institute of Transportation Studies, University of California, Irvine, Irvine, California 92697
Venue:
Transportation Science
Year:
2011

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Abstract

A real 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.