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European Journal of Operational Research 187 (2008) 1368–1379

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The impacts of uncertainties in a real options model

under incomplete information
Takashi Shibata *

Graduate School of Economics, Kyoto University, Sakyo, 606 8501, Japan

Available online 3 November 2006

Abstract

This paper examines the impact with respect to the uncertainty of the underlying state variable, profit uncertainty, on
the real options model in a situation of incomplete information. Profit uncertainty has not incorporated into the real
options model under incomplete information, in that the underlying state variable is not formulated as the stochastic pro-
cess (see, e.g., Bernardo, A. E., Chowdhry, E. B., 2002. Resources, real options, and corporate strategy. Journal of Finan-
cial Economics, 63, 211–234). We extend the model developed by Bernardo and Chowdhry to formulate the underlying
state variable as the stochastic process. We conclude that profit uncertainty has the same type of impact on the real options
value and its triggers, both under complete and incomplete information.
Ó 2006 Elsevier B.V. All rights reserved.

Keywords: Real options valuation methods; Incomplete information theory; Decision analysis; Finance; Kalman filtering

1. Introduction in a standard real options model, the underlying

The standard real options approach (complete
information is assumed) examines the real (project)
options value as well as its trigger (optimal invest-
ment timing). Since we can regard investment deci-
sion making under uncertainty as a financial
option, the investment opportunity is similar to an
American call option written by the underlying state
variable (e.g., profit, price, demand, and so on). The
real options value can then be calculated by option
pricing theory of financial engineering (see, e.g.,
Epps, 2002; Kijima, 2002; for details). Importantly,
state variable is formulated as the stochastic pro-
cess, which enables us to examine the uncertainty
of the state variable (i.e., profit uncertainty). The
main result obtained in this standard framework is
that an increase in profit uncertainty increases the
real options value as well as its trigger. This implica-
tion is that an increase in profit uncertainty
decreases investment. In general, the firm will dis-
play greater inertia in its investment behavior for
greater profit uncertainty. An excellent overview
of the real options approach is found in Dixit and
Pindyck (1994) and Trigeorgis (1996).1

* 1
Tel.: +81 75 753 3495. McDonald and Siegel (1986) provide the standard continu-
E-mail address: shibata@econ.kyoto-u.ac.jp ous-time framework for analysis of a firm’s investment.

0377-2217/$ - see front matter Ó 2006 Elsevier B.V. All rights reserved.
doi:10.1016/j.ejor.2006.09.019
 T. Shibata / European Journal of Operational Research 187 (2008) 1368–1379
Recently, the standard model has been extended
in various ways. One important extension is to the
situation of incomplete information.2 Several stud-
ies have begun the task of incorporating the incom-
plete information into real options model, in that
the firm cannot observe the current realized value
of the underlying state variable completely, which
is why we call these models the incomplete informa-
tion models. The difference between the complete
and incomplete information situation is whether or
not the firm can observe the current realized value
of the underlying state variable completely. In the
former situation the firm can observe the current
realized value, while in the latter situation the firm
cannot observe the current realized value
completely.
Thijssen et al. (2001), and Bernardo and Chow-
dhry (2002) have considered an incomplete informa-
tion situation in a real options model.3 However,
these models formulate the underlying state variable
as the random variable, not as the stochastic pro-
cess. In other words, these models do not examine
the effect of the real (project) options value with
respect to uncertainty of the underlying state vari-
able (i.e., profit uncertainty). It is natural that the
underlying state variable should be formulated as
the stochastic process even in a situation of incom-
plete information. The reason is that the underlying
state variable is assumed typically as a profit, which
fluctuates from time to time. In existing models
under incomplete information, we have not charac-
terized how the real options value depends upon
profit uncertainty. What is of great interest is to
determine how the real options value depends upon
profit uncertainty in a situation of incomplete
information.
This paper analyzes how the real options value is
influenced by the uncertainty of the underlying state
2
Another significant extension is to incorporate strategic
interactions. See, e.g., Weeds (2002), Miltersen and Schwartz
(2004), and Kijima and Shibata (2002, 2005) for details of the real
options approach with strategic interactions.
3
Lambrecht and Perraudin (2003) study the investment timing
decision incorporating both the strategic interactions and incom-
plete information. Nishimura and Osaki (2003) consider the
adoption of project under Knightian uncertainty on the value of
irreversible investment opportunity. Grenadier and Wang (2005)
provide a model of investment timing in the presence of
information asymmetries when the owner delegates the invest-
ment decision to the manager. Décamps et al. (2005) consider the
decision of when to invest in a project whose value is perfectly
observable but driven by a parameter that is unknown to the
decision-maker ex-ante.
1369
variable (profit uncertainty) in a situation of incom-
plete information, assuming that the state variable is
formulated as the stochastic process. This is an
important contribution of this paper. Our settings
force the real options value to depend upon three
kinds of uncertainties, namely, profit uncertainty,
information uncertainty, and estimation uncer-
tainty. The first kind of uncertainty is due to the fact
that the underlying state variable is formulated as
the stochastic process. Only profit uncertainty is
analyzed in the standard real options model (com-
plete information is assumed). The other two uncer-
tainties arise due to extension of incomplete
information model. These uncertainties are exam-
ined in Bernardo and Chowdhry (2002).
The paper is organized as follows. The model is
developed in Section 2. We discuss the set up of
the model, describe the real options value, and
derive the partial differential equation which the real
options value should satisfy. It is not possible to
obtain closed-form analytic expressions for the solu-
tion of this partial differential equation, so in 3 we
use numerical methods to calculate the real options
value and analyze the comparative statics (sensitiv-
ity analyses) under three uncertainty scenarios. Sec-
tion 4 concludes the paper and discusses the
implications for future research.
2. Model
In this section, we begin with a description of the
model. This model is similar to the one developed
by Bernardo and Chowdhry (2002). We extend the
model developed by Bernardo and Chowdhry
(2002) to incorporate the stochastic process as the
underlying uncertainty (In their setting, it is formu-
lated as a random variable). We then provide the
partial differential equation that the real options
value of the firm should satisfy.
2.1. Setup
Throughout our analysis, we suppose that capital
markets are frictionless, an agent is risk neutral and
can borrow and lend freely at a constant, interest
rate, r. The assumption of risk neutrality represents
little loss of generality. If an agent is risk averse, the
analysis may be developed under risk neutral rather
than actual probabilities (see Harrison and Kreps,
1979).
Now we consider a firm having an investment
opportunity. Let the stochastic process, ðhÞt2Rþ , rep-
1370 T. Shibata / European Journal of Operational Research 187 (2008) 1368–1379
resent the underlying uncertainty (state variable) for
carrying out the investment. The process, ðht Þt2Rþ , is
defined on a complete filtered probability space
ðX; P; fFt gt2Rþ ; FÞ. The profit of carrying out the
investment at the time t is equal to Kht where
Kð2 Rþ n ½0; 1Þ is assumed to be a positive constant.
We can regard parameter K as a scale-up factor.
Similar to the assumption in a standard real options
model, the investment is assumed to be irreversible,
in that once the firm invests, the firm cannot cease
its operation. For simplicity, the cost to adopt the
investment is assumed to remain zero. Since the cost
to adopt the investment is often assumed to be some
constant in the standard real options model, the
assumption that the cost is zero represents little loss
of generality.4
We assume that ðht Þt2Rþ evolves continuously
according to a mean reverting (Ornstein–Uhlen-
beck) process:
dht ¼ aðm  ht Þdt þ rb dzbt ; h0  Nðl0 ; v0 Þ: ð1Þ
Here, a, m, and rb are strictly positive constants.
The instantaneous mean is proportional to the dif-
ference between the value of m and the value of ht.
rb represents the uncertainty of the underlying state
variable, i.e., profit uncertainty. h0 is a Gaussian
random variable with expectation l0 and variance
v0, i.e., N stands for Normal distribution. ðzbt Þt2Rþ
represents an Ft -standard Brownian motion. If all
the coefficients in Eq. (1) are zero (i.e., dht = 0),
the model turns out to be exactly the same as the
one developed by Bernardo and Chowdhry (2002,
Section 3).
In our model, the most important assumption is
that the firm cannot observe the current realized
value of ðht Þt2Rþ completely. This is why we call
our model an incomplete information model. How-
ever, we assume that the firm knows that ðht Þt2Rþ is
4
Even if the investment cost is a positive constant, this
assumption does not influence the results obtained in this paper
in the basic sense. Concretely speaking, if the investment cost is a
positive constant, the positive payoff (value of carrying out the
investment) starts at a positive level dependent upon the
investment cost instead of zero. In Dixit and Pindyck (1994,
Chapter 5), since the underlying state variable follows the
geometric Brownian motion, the realized value of the underlying
state variable takes a positive value only. So, the investment cost
is assumed to be a positive constant. On the other hand, since the
underlying state variable in this paper follows an Ornstein–
Uhlenbeck process, the realized value can possibly take a negative
value. Thus as in Bernardo and Chowdhry (2002) we can assume
that the investment cost remains zero, for simplicity.
given in Eq. (1), and can filter (or extract) the infor-
mation about the current realized value of ðht Þt2Rþ
through some activity in itself. In this model, we call
this action the initial activity. In practice, we can
regard the initial activity (act of filtering) as research
and development, marketing, and so on. Thus the
firm can filter the information about the current
realized value of ðht Þt2Rþ through the initial activity.
We assume that the firm can start and stop carry-
ing out the initial activity without any costs,5 and
can get the cash flow from carrying out it. We
denote the cumulative cash flow of the initial activ-
ity at time t by ðnt Þt2Rþ defined on the same complete
filtered probability space ðX; P; ðFt Þt2Rþ ; FÞ, so
that the instantaneous net cash flow is given by
dnt. ðnt Þt2Rþ evolves continuously according to:
dnt ¼ ht dt þ ra dzat ; n0 ¼ 0; ð2Þ
where ðzat Þt2Rþ represents an Ft -standard Brownian
motion, and ra represents the constant diffusion
coefficient, i.e., information uncertainty. This is be-
cause the quality of the information depends upon
the parameter ra. In the limiting case when ra = 0,
the firm learns ht perfectly in the first instant dt,
while in the limiting case when ra goes to infinity
the firm learns nothing about ht. We assume that
ðzat Þt2Rþ , ðzbt Þt2Rþ , and h0 are independent of each
other. This assumption implies that the noise of
the profit for the investment is independent with
that for the initial activity. However, since the drift
term of Eq. (2) is ht, there is a positive relationship
between the profit for the investment and the initial
activity. We introduce the scale-up parameter, K, in
order to induce the magnitude difference between
them.
It may be recalled that the drift term of Eq. (2)
includes ðht Þt2Rþ , although the firm can observe the
process ðnt Þt2Rþ completely. Thus, the firm turns
5
If there is a cost to start carrying out the initial activity, we
must consider whether or not the firm carries out the initial
activity. Then, the model turns out to be a compounded options
model (see Geske, 1979; for details of the compounded options).
It may be recalled that our aim is to focus on the incomplete
information situation on the investment. If the cost to stop
carrying out the initial activity is a positive constant, the positive
payoff (value of carrying out the investment) starts at the positive
level dependent upon the cost of stopping the initial activity
instead of zero. So, the assumption that the cost of stopping the
initial activity is zero does not influence the results obtained in
this model. For simplicity, we assume that there is no cost to stop
carrying out the initial activity.
 T. Shibata / European Journal of Operational Research 187 (2008) 1368–1379 1371
 
out to filter the information about ðht Þt2Rþ through v2t
dvt ¼ 2avt þ r2b  2 dt; ð4Þ
ðnt Þt2Rþ . Let Fnt denote the smallest r-algebra with ra
respect to ðnt Þt2Rþ . One should interpret the r-alge-
bra, Fnt , as the information for the investment avail- respectively.9
able to the firm at time t. Since Fnt  Ft (strictly Eq. (3) has the same form as the usual inference
speaking, Fnt  Ft , Fnt 6¼ Ft , i.e., the former is equation of Gaussian variables. Furthermore, we
strictly smaller than the latter), our model turns state an important lemma in Kalman filtering the-
out to be an incomplete information model. ory (see e.g., Øksendal, 2003; for the proof of the
In summary, the firm can observe ðnt Þt2Rþ , following lemma).
whereas the firm cannot observe ðht Þt2Rþ . The firm Lemma 2.1. The following process, ðRt Þt2Rþ , which is
seeks to filter information concerning ðht Þt2Rþ here defined as
though ðnt Þt2Rþ . At time 0, the firm views the distri-
bution of h0 as a Gaussian distribution. The firm 1
should find the ‘‘best’’ estimate of the underlying dRt ¼ dN t ; ð5Þ
ra
state variable ðht Þt2Rþ given observable information
is an Fnt -standard Brownian motion, where the inno-
Fnt up to time t.6 The Kalman filtering problem is
vation process, ðN t Þt2Rþ , is defined by:
to find the ‘‘best’’ estimate of the state variable
Z t
ðht Þt2Rþ on the basis of observable information up
N t ¼ nt  ls ds: ð6Þ
to time t.7 Thus the ‘‘best’’ estimate of the underly- 0
ing state variable ðht Þt2Rþ given observable informa-
Importantly, Lemma 2.1 implies that the process
tion Fnt can be derived by using the Kalman
ðzat Þt2Rþ is not an Fnt -standard Brownian motion,
filtering theory.8
although it is an Ft -standard Brownian motion.
On the other hand, the conditional variance is
2.2. Real options value given by Eq. (4). Eq. (4) is called the Riccati equa-
tion of the theory of ordinary differential equations.
In this subsection, we begin with presenting both In Appendix, we prove the following lemma.
the conditional expectation and variance of unob-
servable variable, ðht Þt2Rþ , by Kalman filtering pro- Lemma 2.2. The solution of the ordinary differential
cedure. We then provide the partial differential Eq. (4) is obtained as follows:
equation that the real options value should satisfy.
We denote the conditional expectation and vari- ða2 a1 Þt
r2
ance of ht by: a1 þ Ba2 e a
vt ¼ ða2 a1 Þt
;
lt ¼ E½ht jFnt ; and vt ¼ E½ðht  lt Þ 2
jFnt ; 1 þ Be r2a
 qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
where a1;2 ¼ ar2a  ra a2 r2a þ r2b ;
respectively. According to the Kalman filtering pro-
v 0  a1
cedure, the conditional expectation and variance B¼ :
a2  v 0
satisfy the following equations:
  Here, a1, a2 are positive, negative constants, respec-
vt 1 tively. Furthermore, the conditional variance vt con-
dlt ¼aðm  lt Þdt þ ðdnt  lt dtÞ ; ð3Þ
ra ra verges to a1 as time goes to infinity.
Lemma 2.2 implies that the conditional variance
6
The ‘‘best’’ is understood in the sense of the smallest does not disappear as time goes to infinity. For suf-
prediction error.
7 ficiently large time t we have vt  a1.
An excellent overview of the Kalman filtering problem is
found in Liptser and Shiryaev (2001a,b), and Øksendal (2003). Since we have an arrangement necessary to
The tools of Kalman filtering procedure have often used in obtain the partial differential equation that the real
several studies. For example, see Gennotte (1986), Brennan options value should satisfy in our setting, we then
(1998), Xia (2001), Bernardo and Chowdhry (2002) and Décamps examine the real options value. The function for
et al. (2005).
8
As for Kalman filtering theory, we refer to Eqs. (1), (2) as the
9
‘‘system equation’’, ‘‘observation equation’’, respectively. See, See Liptser and Shiryaev (2001a, Theorem 10.1) for derivation
e.g., Øksendal (2003, §6.1). of the conditional expectation and variance.
1372 T. Shibata / European Journal of Operational Research 187 (2008) 1368–1379

the real options value satisfies the following Bellman KlH

equation:
  
rdt n Kht n
V t ¼ max 0; E½dnt þ e V tþdt jFt ; E F :
r t
ð7Þ
Each term in Eq. (7) represents the real options va-
lue according to the particular decision taken. The
first term represents the value when ceasing the ini-
tial activity, i.e., closing all operation. It may be re-
called that the firm can start and stop carrying out
the initial activity without any costs. The second
term represents the value of delaying the decision
as to whether operation ceases or extends. This term
consists of two components, the instantaneous net
cash flow from the initial activity, and the options
value for carrying out the investment. The last term
is the value when carrying out the investment. It
may be noted that the profit from carrying out the
investment is expressed as a cash flow in perpetuity,
2
because the investment is assumed to be irreversible.
The real options value of delaying decision mak-
ing is rewritten as:
V t ¼ E½dnt þ ð1  rdtÞðV t þ dV t ÞjFnt : ð8Þ
Since the value of delaying decision making can be
thought of as an American option with infinite
maturity (i.e., the perpetual American option), the
value function Vt depends just upon the two vari-
ables lt, vt, so can write Vt = V(lt, vt). Using Ito’s
formula, we have:
 
vt
dV ðlt ; vt Þ ¼ V l aðm  lt Þdt þ 2 ðdnt  lt dtÞ
ra

 
2 v2t
þ V v 2avt þ rb  2 dt
ra
"
 # tion regions by means of numerical methods in the
2
1 vt
þ V ll dt ; ð9Þ
2 ra
V ðlH ; vÞ ¼ ; ð12Þ
r
V l ðlL ; vÞ ¼ 0; ð13Þ
K
V l ðlH ; vÞ ¼ ; ð14Þ
r
where lL, lH stand for the lower, upper trigger for
fixed v, respectively. That is to say, the former is
the trigger of ceasing the operation; the latter is
the trigger of extending the operation. From now
on we call the region of delaying decision making,
(lL, lH), the continuation region. The boundary
conditions are the so-called value-matching and
smooth-pasting conditions. Eqs. (11) and (12) are
the value-matching conditions. Eqs. (13) and (14)
are the smooth-pasting conditions. Moreover, the
real options value of delaying decision making for
a sufficiently large time satisfies the ordinary differ-
ential equation:
1 v
V ll þ V l aðm  lÞ þ l  rV ¼ 0: ð15Þ
2 ra
The fact that Eq. (15) is obtained follows from
that the conditional variance does not converge to
zero for a large time but rather to a1, the positive
root of the quadratic equation.
Since the continuation region, (lL, lH), is
unknown in this model, we have to obtain both
the solutions of the partial and ordinary differential
equations and the continuation regions simulta-
neously. This type of problem is known as a free
boundary value problem. As we cannot, however,
solve the differential equations (10) and (15) in
closed-form under the given boundary conditions,
we examine these value functions and the continua-
following section.

where Vi, Vii (i 2 {l, v}) denote partial derivative. 3. Numerical results
Substituting (9) into (8), we obtain the partial differ-
ential equation that the real options value of delay- In this section, we use numerical methods to cal-
ing decision making should satisfy: culate the real options value and continuation

2
 region and analyze the comparative statics (sensitiv-
1 v v2
V ll þ V v 2av þ r2b  2 ity analyses) under three uncertainty scenarios. Sec-
2 ra ra
tion 3.1 discusses how to calculate the real options
þ V l aðm  lÞ þ l  rV ¼ 0: ð10Þ value by the use of numerical methods. Section 3.2
The corresponding boundary conditions are as describes the choice of parameters used in the subse-
follows: quent numerical analysis of the real options value.
Sections 3.3–3.7 analyze the comparative statics
V ðlL ; vÞ ¼ 0; ð11Þ with respect to several key parameters.
 T. Shibata / European Journal of Operational Research 187 (2008) 1368–1379
3.1. Methods of numerical calculation
In this subsection, we consider how to calculate
the real options value of the firm by the use of
numerical methods. We use a standard finite differ-
ence method, in particular the penalty method, to
numerically solve the value and continuation region
simultaneously.10
Let the value at the triggers be denoted by V*, the
partial differential equation can then be written as:
K P 0; ðV  V  Þ P 0; ðV  V  ÞK ¼ 0;
2
 r = 0.2, K = 8, m = 0.2, ra = 0.1. Thus the bench-
1 v v2
where K :¼ V ll 2 þ V v 2av þ r2b  2
2 ra ra
þ V l aðm  lÞ þ l  rV :
ð16Þ
If V > V *,
then the first term of Eq. (16) satisfies
the equality, and the equation coincides with the
partial differential equation (10). On the other hand,
if V 6 V*, then it is natural for the firm to exercise,
so the first term of Eq. (16) need not satisfy the
equality. Thus Eq. (16), for some large number q,
is rewritten as:
K þ q maxfV   V ; 0g ¼ 0: ð17Þ
If V > V*, then the partial differential equation (17)
must easily satisfy the equality, whereas if V 6 V*,
then for some large number q, the term q(V*  V)
in Eq. (17) dominates the equation, and the equality
V* = V must be satisfied. This technique is called a
penalty method.11 We use the penalty method to
analyze numerically the value and continuation re-
gion simultaneously (see, e.g., Bernardo and Chow-
dhry, 2002; for details of numerical methodology).
3.2. Parameter calibration
Some of the calibrated parameters (rb, a) have
been chosen so that the instantaneous conditional
variance vt in (4) is decreasing over time. It seems
10
See, e.g., Brandimarte (2002, Chapter 3), Seydel (2002,
Chapter 4) for details of numerical method.
11
This is a definition of the penalty method (Forsyth and Vetzal,
2002, Section 3). Forsyth and Vetzal (2002, Theorem 6.1) showed
that the convergence of a penalized equation for solving the
discrete regularized American option valuation problem is
studied, and that the iteration converges to the unique solution.
As another common technique involved for solving the discrete
linear complementarity problem, there are relaxation method,
interior point algorithms and so on.
1373
desirable that this source of uncertainty should
decrease as the process evolves.12 Moreover, this
parameter setting leads to satisfying the stability
of partial differential equation (10).
The other parameters (ra, m, K, r) have been cho-
sen based on those used by Bernardo and Chow-
dhry (2002, §3.1.1). Since our aim here is to focus
on the comparative statics with respect to several
key parameters, we felt that the parameters used
by Bernardo and Chowdhry (2002) would be appro-
priate for the remaining parameters.13 I choose
mark parameters used are as follows; ra = 0.1,
rb = 0.025, m = 0.2, K = 8.0, r = 0.2, a = 0.1. For
the numerical result reported here, we set the
parameter q = 100. The numerical results remain
unchanged for other choices of the parameter q,
e.g., we have also used q = 500, 1000.
3.3. Real options value as benchmark
Fig. 1 depicts the real (project) options value as
the function of the conditional expectation l for
fixed conditional variance v = 0.15. With bench-
mark parameters as shown previously, we find that
the continuation region (lL, lH) is calculated as
(0.30,0.21), and the value is 2.0090 for fixed levels
(l = 0, v = 0.15). For sufficiently large time t, the
value is determined by the limiting ordinary differ-
ential equation (15), and depicted by the dashed
line. Fig. 1 shows that the real options value
decreases over time. In the following subsequent
subsection, we examine the comparative statics (sen-
sitivity analyses) of both the real options value and
continuation regions with respect to various key
parameters.
12
Since vt is the conditional variance of the state variable ht with
respect to the information available to the firm Fnt , it can be
regarded as estimation uncertainty about the state variable.
Furthermore, we know that the conditional variance converges to
an arbitrary value a1 when times goes to infinity (Lemma 2.2).
Thus as time passes, it is more natural to decrease estimation
uncertainty. Moreover, this reflects the experience accumulated
by the firm in the practical considerations. If the conditional
variance vt was increasing over time, the firm would have less the
option to wait and the problem would be less interesting. So, we
select the parameters in order to be in the situation of a
decreasing conditional variance vt.
13
Even if we choose the other parameters, the obtained results
remain the same in the basic sense.
1374 T. Shibata / European Journal of Operational Research 187 (2008) 1368–1379

5
value of delaying
4
value of delaying
3 when time goes infity

1
value of carrying out
0

-1
-0.25 -0.2 -0.15 -0.1 -0.05 0 0.05 0.1 0.15 0.2

Fig. 1. Real options value and continuation regions: this figure shows that the real (project) options value as a function of the conditional
expectation for fixed conditional variance (v = 0.15). Other parameters are fixed at the base levels: ra = 0.1, rb = 0.025, m = 0.2, K = 8,
r = 0.2, a = 0.1. For l < 0.30, it is optimal for the firm to cease the operation. For l > 0.21, the firm optimally extend the operation. At
l = 0, the real options value is approximately 2.0090.

3.4. Sensitivity to profit uncertainty
In this subsection, we examine the comparative
statics with respect to the uncertainty of the under-
lying state variable (profit uncertainty), rb. Note
that in our setting, the firm cannot observe
ðht Þt2Rþ . However, assuming that the firm knows
that the system equation ðht Þt2Rþ follows the differ-
ential equation (1), the firm knows the parameter
level of the system equation. The fact enables the
firm to filter the information about the unobserv-
able process, ðht Þt2Rþ . That is to say, although the
firm cannot observe the current realized value of
ðht Þt2Rþ , the firm knows the parameter level included
in Eq. (1), e.g., rb. Now consider how the real
options value depends upon several choice of rb.
In Fig. 2, we demonstrate the real options value
as a function of l for several choices of profit uncer-
tainty rb. For fixed (l, v), an increase in profit uncer-
tainty increases the value. As profit uncertainty rb
increases from 0.00 to 0.05, the real options value
V increases from 1.9417 to 2.1400 for fixed levels
(l = 0, v = 0.15). At the same time, the continuation
region (lL,lH) expands from (0.29, 0.21) to
(0.32, 0.22), i.e., the lower trigger lL is decreasing
in rb, and the upper trigger lH is increasing in rb.
Although one may consider that this effect is not
very significant, it follows that we keep the parame-
ters shift very small in order to satisfy the stability
of partial differential equation (10).
These numerical simulations suggest:
Observation 3.1. An increase in profit uncertainty
increases the real options value as well as the
continuation region, even in a situation of incom-
plete information.
This result is exactly the same as one in the stan-
dard real options model (where complete informa-
tion is assumed). See e.g., Dixit and Pindyck
(1994, §5.4). In existing real options model in a sit-
uation of incomplete information such as Bernardo
and Chowdhry (2002), profit uncertainty has not yet
been introduced. To my knowledge, our numerical
experiments indicate for the first time that the real
options value as well as the continuation region
increases as profit uncertainty increases, even in a
real options model under incomplete information.
The main conclusion of this paper is that profit
uncertainty has the same type of effect on the real
options value and its triggers, both under complete
and incomplete information.
The result obtained by Observation 3.1 demon-
strates the following implication. In general, if the
firm knows that the underlying state variable (e.g.,
price, revenue, demand, and so on) is more volatile
even although the firm cannot observe the realized
 T. Shibata / European Journal of Operational Research 187 (2008) 1368–1379 1375

5
value of delaying
4 when sigma beta = 0.05

3 value of delaying
when sigma beta = 0.00
2
value of carrying out
1

-1
-0.25 -0.2 -0.15 -0.1 -0.05 0 0.05 0.1 0.15 0.2 0.25

Fig. 2. Comparative statics with respect to profit uncertainty rb: real (project) options value for l are plotted for two different values of
profit (for the project) uncertainty, rb. Other parameters are fixed at the base levels: ra = 0.1, rb = 0.025, m = 0.2, K = 8, r = 0.2, a = 0.1.
An increase in profit uncertainty increases the real options value as well as the continuation region.

value of the state variable completely, the firm dis- variable is formulated as a stochastic process in a
plays greater inertia in its investment behavior. situation of incomplete information.
This result is in accordance with that in Bernardo
3.5. Sensitivity to information uncertainty
and Chowdhry (2002, §3.1.3), even assuming that
unobservable component, ðht Þt2Rþ , follows the sto-
In the subsequent Sections 3.5–3.7, we examine
chastic process. Needless to say, this result is exactly
exactly the same comparative statics as ones ana-
the opposite as one obtained in previous subsection.
lyzed in Bernardo and Chowdhry (2002). However,
This is because low level of ra means that the firm
this model is different from one developed by
will learn more by filtering (or extracting) informa-
Bernardo and Chowdhry (2002), in that the unob-
tion about ðht Þt2Rþ , allowing it to follow a superior
servable component is formulated as the stochastic
investment policy in the future. Thus we get the
process, not as the random variable. In this subsec-
opposite result compared with those of the standard
tion, we consider the comparative statics with
real options model.
respect to information uncertainty ra.
In Fig. 3, we see the real options value as a func-
3.6. Sensitivity to estimation uncertainty
tion of l for several choices of ra. For fixed (l, v), an
increase in information uncertainty ra decreases the
Now we examine the comparative statics with
real options value V. For instance, as information
respect to the conditional variance of the state var-
uncertainty ra increases from 0.05 to 0.15, the real
iable, v. We can regard the conditional variance v as
options value V decreases from 2.4288 to 1.7641
estimation (or conjecture) uncertainty, because v is
for fixed levels (l = 0, v = 0.15). At the same time,
mean square error of filtering. The comparative
the continuation region (lL, lH) reduces from
statics with respect to v is quite different from that
(0.42, 0.29) to (0.26, 0.17), i.e., the lower trigger
of the other parameters, e.g., ra, rb. This is so since
lL is increasing in ra, and the upper trigger lH is
the real options value function V(l, v) depends upon
decreasing in ra. These numerical simulations sug-
the two variables (l, v) in this model, and so we are
gest the following observation:
now considering the effect on the real options value
Observation 3.2. An increase in information uncer- of the change in an endogenous variable.
tainty decreases the real options value as well as the In Fig. 4, we see the real options value as the
continuation region, even when the underlying state function of l for several choices of v. For fixed l,
1376 T. Shibata / European Journal of Operational Research 187 (2008) 1368–1379

10

value of delaying
6
when sigma alpha = 0.05

4
value of delaying
when sigma alpha = 0.15
2

value of carrying out

0

-0.5 -0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3

Fig. 3. Comparative statics with respect to information uncertainty ra: real (project) options value for l are plotted for two different
values of information uncertainty, ra. Other parameters are fixed at the base levels: ra = 0.1, rb = 0.025, m = 0.2, K = 8, r = 0.2, a = 0.1.
An increase in information uncertainty decreases the real options value as well as the continuation region.

16

14

12

10 value of delaying
when variance = 0.20
8

6
value of delaying
4 when variance = 0.10

0 value of carrying out

-0.5 -0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4 0.5

Fig. 4. Effect of estimation uncertainty v: real (project) options value for l are plotted for two different values of estimation uncertainty, v.
Other parameters are fixed at the base levels: ra = 0.1, rb = 0.025, m = 0.2, K = 8, r = 0.2, a = 0.1. An increase in estimation uncertainty
increases the real options value as well as the continuation region.

the value V is increasing in v. For instance, as con-
ditional variance v increases from 0.10 to 0.20, the
value V increases from 1.2529 to 3.2120 for fixed
level (l = 0). At the same time, the continuation
region (lL, lH) expands from (0.18, 0.12) to
(0.59, 0.43), i.e., the lower trigger lL is decreasing
in v, and the upper trigger lH is increasing in v.
These numerical simulations suggest the following
observation:
Observation 3.3. An increase in estimation uncer-
tainty increases the real options value as well as the
 T. Shibata / European Journal of Operational Research 187 (2008) 1368–1379 1377

continuation region, even when the underlying state we see that the value is increasing in m. This is
variable is formulated as a stochastic process in a because the revenue of the firm is increasing in the
situation of incomplete information. level mean-regression though we note that this is
not a strong effect.
The result is also exactly the same as one Finally, we consider in Table 1 the impact on the
obtained in Bernardo and Chowdhry (2002, real options value of the parameter a. This parame-
§3.1.2), even assuming that the underlying state var- ter captures the speed of mean-reversion. Our com-
iable follows the stochastic process. putations have shown that the real options value
does not change significantly with respect to the
3.7. Sensitivity to other parameters parameter a.
The parameter K may be thought of as the scale- 4. Conclusions
up parameter when carrying out investment. In
Table 1, we examine the real options value with dif- This paper examines the real options model
ferent levels for K. As the magnitude of the option under a situation of incomplete information. In
to expand K increases, the value increases from the standard real options model (where complete
2.0090 to 3.0320 for fixed levels (l = 0, v = 0.15). information is assumed), one of the most important
This is clearly because the revenue from making propositions is that an increase in the uncertainty of
the irreversible investment is increasing in K. We the underlying state variable, profit (for the project)
also find that the continuation region (lL, lH) is uncertainty, increases the real options value as well
almost the same for all K. This could be explained as its trigger (see, e.g., Dixit and Pindyck, 1994; Tri-
by the fact that the positive effect on the continua- georgis, 1996). In existing real options model in a
tion region for increasing option value is offset by situation of incomplete information such as Ber-
the negative effect on it of making decision earlier. nardo and Chowdhry (2002), and Thijssen et al.
Next, we examine in Table 1 the real options (2001), profit uncertainty has not previously been
value with different values of the parameter m. Here introduced, in that the underlying state variable is
not formulated as the stochastic process. Thus, we
Table 1 incorporate profit uncertainty in a setting under
Numerical results incomplete information, and analyze its compara-
lL lH V(l = 0, v = 0.15) tive statics numerically. The main conclusion in this
ra 0.05 0.42 0.29 2.4288 paper is that profit uncertainty has the same type of
0.10 0.30 0.21 2.0090 effect on the real options value and its triggers, both
0.15 0.26 0.17 1.7641 under complete and incomplete information. This
rb 0.00 0.29 0.21 1.9417 result demonstrates the following implication. If
0.025 0.30 0.21 2.0090 the firm knows that the underlying state variable
0.05 0.32 0.22 2.1400 (e.g., price, revenue, demand, and so on) is more
K 4 0.27 0.22 0.9946 volatile even although the firm cannot observe the
8 0.30 0.21 2.0090 realized value of the underlying state variable com-
12 0.32 0.21 3.0320 pletely, the firm displays greater inertia in its invest-
m 0.2 0.30 0.21 2.0090 ment behavior. At the same time, we find that
0.3 0.32 0.22 2.0515 similarly to the result obtained in Bernardo and
a 0.1 0.30 0.21 2.0090 Chowdhry (2002), an increase in information uncer-
0.2 0.31 0.21 2.0124 tainty decreases the real options value and its trig-
lL lH V(l = 0,v) gers, and an increase in estimation uncertainty
v 0.10 0.18 0.12 1.2529 increases the real options value and its triggers, even
0.15 0.30 0.21 2.0090 assuming that the state variable follows the stochas-
0.20 0.59 0.43 3.2120
tic process. Thus we investigate the impact of vari-
This table reports the real options value V as well as the con- ous uncertainties in the real options model in a
tinuation region (lL,lK) with respect to various values of key
situation of incomplete information.
parameters. Let l and v denote the conditional expectation,
variance of the state variable, respectively. This table demon- As real options theory has developed rapidly,
strates that how the real options value depends upon various there remains room for its refinement in a number
values of several key parameters. of directions. In future research, it would be desir-
1378 T. Shibata / European Journal of Operational Research 187 (2008) 1368–1379

able to develop the model in various ways depend- Recalling that the general solution for ordinary
b1 t
ing upon the situation at hand. For example, in this differential equation (A.2) is u ¼ A 0
1e þ A2 eb2 t ,
2 u ðtÞ
paper, we cannot obtain closed form solutions for and that v is defined by vðtÞ ¼ ra uðtÞ , we obtain
the real options value. We will investigate both the general solution of v(t):
closed form solutions and the impact on the real
A1 b1 eb1 t þ A2 b2 eb2 t
options value under the different setting in a situa- vðtÞ ¼ r2a ; ðA:3Þ
A1 eb1 t þ A2 eb2 t
tion of incomplete information.
where
Acknowledgements  qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
b1;2 ¼ r2
a ar2
a  r a a2 r2a þ r2b :
This paper is based on a part of my Ph.D. thesis
Note that b1, b2 are the positive, negative root of
which was submitted to Kyoto University in 2004. I
quadratic equation. Furthermore, Eq. (A.3) may be
am grateful to Carl Chiarella, Hajime Fujiwara, and
rewritten as:
especially to my Ph.D. advisor Masaaki Kijima for
ða2 a1 Þt
many suggestions and their encouragement. Any
a1 þ AA21 a2 e r2
a
errors remain my responsibility. I am grateful for vðtÞ ¼ ;
ða2 a1 Þt
discussion at 20th European Conference on Opera- 1 þ AA21 e r2
a
tional Research 2004, International Conference on
Computing in Economics and Finance 2004, and where
Quantitative Methods in Finance Conference  qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
2004. I thank two anonymous referees, Professor a1;2 ¼ ar2a  ra a2 r2a þ r2b :
Bisdorff (the editor), Professor Meyer (the editor
of the EJOR EURO 2004 feature issue) for their Taking into consideration the initial condition at
valuable comments. This research was partially sup- time t = 0 °C we get
ported by MEXT, Grant-in-Aid for Scientific Re- A2 vð0Þ  a1
¼ :
search 2B 17710128. A1 a2  vð0Þ
A2
is a constant. Finally, using the fact that
Appendix A1
a1  a2 > 0 because of a1 > 0 and a2 < 0, v(t) con-
verges into a1 as time goes to infinity. Therefore,
Proof of Lemma 2.2. It may be recalled that Eq. (4)
we obtain vðtÞ  a1 ða1 2 Rþþ Þ for sufficiently large
is the Riccati equation when written as:
time t. h

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