Application of stochastic differential equations and real option theory in investment decision problems

This thesis contains a discussion of four problems arising from the application of stochastic differential equations and real option theory to investment decision problems in a continuous-time framework. It is based on four papers written jointly with the author’s supervisor. In the first problem, we study an evolutionary stock market model in a continuous-time framework where uncertainty in dividends is produced by a single Wiener process. The model is an adaptation to a continuous-time framework of a discrete evolutionary stock market model developed by Evstigneev, Hens and Schenk-Hoppé (2006). We consider the case of fix-mix strategies and derive the stochastic differential equations which determine the evolution of the wealth processes of the various market players. The wealth dynamics for various initial set-ups of the market are simulated. In the second problem, we apply an entry-exit model in real option theory to study concessionary agreements between a private company and a state government to run a privatised business or project. The private company can choose the time to enter into the agreement and can also choose the time to exit the agreement if the project becomes unprofitable. An early termination of the agreement by the company might mean that it has to pay a penalty fee to the government. Optimal times for the company to enter and exit the agreement are calculated. The dynamics of the project are assumed to follow either a geometric mean reversion process or geometric Brownian motion. A comparative analysis is provided. Particular emphasis is given to the role of uncertainty and how uncertainty affects the average time that the concessionary agreement is active. The effect of uncertainty is studied by using Monte Carlo simulation. In the third problem, we study numerical methods for solving stochastic optimal control problems which are linear in the control. In particular, we investigate methods based on spline functions for solving the two-point boundary value problems that arise from the method of dynamic programming. In the general case, where only the value function and its first derivative are guaranteed to be continuous, piecewise quadratic polynomials are used in the solution. However, under certain conditions, the continuity of the second derivative is also guaranteed. In this case, piecewise cubic polynomials are used in the solution. We show how the computational time and memory requirements of the solution algorithm can be improved by effectively reducing the dimension of the problem. Numerical examples which demonstrate the effectiveness of our method are provided. Lastly, we study the situation where, by partial privatisation, a government gives a private company the opportunity to invest in a government-owned business. After payment of an initial instalment cost, the private company’s investments are assumed to be flexible within a range [0, k] while the investment in the business continues. We model the problem in a real option framework and use a geometric mean reversion process to describe the dynamics of the business. We use the method of dynamic programming to determine the optimal time for the private company to enter and pay the initial instalment cost as well as the optimal dynamic investment strategy that it follows afterwards. Since an analytic solution cannot be obtained for the dynamic programming equations, we use quadratic splines to obtain a numerical solution. Finally we determine the optimal degree of privatisation in our model from the perspective of the government