IDEAS home Printed from https://ideas.repec.org/a/eee/transa/v118y2018icp714-729.html
   My bibliography  Save this article

Market driven ship investment decision using the real option approach

Author

Listed:
  • Kou, Ying
  • Luo, Meifeng

Abstract

This paper analyzes ship investment behavior where the main driving force is future freight earnings. The shipping market is cyclic and uncertain, and the decision is whether to invest ships now or later. Theoretically, we found the trigger rates—the necessary freight rates for profitable ship investment—for both the net present value (NPV) and real option approach (ROA), assuming that future freight earnings follow a mean reverting stochastic process. The combination of these trigger rates provides the necessary and sufficient conditions for immediate investment. Empirically, we estimated the trigger rates for the whole sample from January 1976 to July 2014, as well as sub-samples that take into account structural changes in the shipping market. Both theoretical and empirical results show that ship investment decisions can be made based on the relationships between the current freight rate and the trigger rates from NPV and ROA. If the freight rate cannot make NPV positive, no investment should be considered. Immediate investment is only recommended when the freight rate is higher than the trigger rate using ROA. Sensitivity analysis shows that the trigger rate is most sensitive to changes in the long-run mean of the freight rate. A simple regression analysis indicates that our model can explain market driven ship investment activities in the past. In addition, results that incorporate structural breaks in the shipping market are closer to actual investment behavior in the market.

Suggested Citation

  • Kou, Ying & Luo, Meifeng, 2018. "Market driven ship investment decision using the real option approach," Transportation Research Part A: Policy and Practice, Elsevier, vol. 118(C), pages 714-729.
    • Handle: RePEc:eee:transa:v:118:y:2018:i:c:p:714-729
    DOI: 10.1016/j.tra.2018.10.016
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0965856415300355
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.tra.2018.10.016?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Ying Kou & Meifeng Luo, 2016. "Strategic capacity competition and overcapacity in shipping," Maritime Policy & Management, Taylor & Francis Journals, vol. 43(4), pages 389-406, May.
    2. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474.
    3. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-157, April.
    4. Pindyck, Robert S, 1982. "Adjustment Costs, Uncertainty, and the Behavior of the Firm," American Economic Review, American Economic Association, vol. 72(3), pages 415-427, June.
    5. Pindyck, Robert S, 1988. "Irreversible Investment, Capacity Choice, and the Value of the Firm," American Economic Review, American Economic Association, vol. 78(5), pages 969-985, December.
    6. Metcalf, Gilbert E. & Hassett, Kevin A., 1995. "Investment under alternative return assumptions Comparing random walks and mean reversion," Journal of Economic Dynamics and Control, Elsevier, vol. 19(8), pages 1471-1488, November.
    7. Ying Kou & Meifeng Luo, 2015. "Modelling the Relationship between Ship Price and Freight Rate with Structural Changes," Journal of Transport Economics and Policy, University of Bath, vol. 49(2), pages 276-294, April.
    8. Peter Lorange, 2001. "Strategic re-thinking in shipping companies," Maritime Policy & Management, Taylor & Francis Journals, vol. 28(1), pages 23-32, January.
    9. Robert McDonald & Daniel Siegel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 101(4), pages 707-727.
    10. Grenadier, Steven R. & Weiss, Allen M., 1997. "Investment in technological innovations: An option pricing approach," Journal of Financial Economics, Elsevier, vol. 44(3), pages 397-416, June.
    11. Lin, Tyrone T. & Huang, Shio-Ling, 2011. "Application of the modified Tobin's q to an uncertain energy-saving project with the real options concept," Energy Policy, Elsevier, vol. 39(1), pages 408-420, January.
    12. Helen B. Bendall & Alan F. Stent, 2007. "Maritime investment strategies with a portfolio of real options," Maritime Policy & Management, Taylor & Francis Journals, vol. 34(5), pages 441-452, October.
    13. Jostein Tvedt, 2003. "Shipping market models and the specification of freight rate processes," Maritime Economics & Logistics, Palgrave Macmillan;International Association of Maritime Economists (IAME), vol. 5(4), pages 327-346, December.
    14. Manolis G. Kavussanos & Amir H. Alizadeh, 2002. "Efficient pricing of ships in the dry bulk sector of the shipping industry," Maritime Policy & Management, Taylor & Francis Journals, vol. 29(3), pages 303-330.
    15. Dixit, Avinash K, 1989. "Entry and Exit Decisions under Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 97(3), pages 620-638, June.
    16. Manolis G. Kavussanos & Amir H. Alizadeh-M, 2002. "The Expectations Hypothesis of the Term Structure and Risk Premiums in Dry Bulk Shipping Freight Markets," Journal of Transport Economics and Policy, University of Bath, vol. 36(2), pages 267-304, May.
    17. Tsekrekos, Andrianos E., 2010. "The effect of mean reversion on entry and exit decisions under uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 34(4), pages 725-742, April.
    18. Helen B Bendall & Alan F Stent, 2005. "Ship Investment under Uncertainty: Valuing a Real Option on the Maximum of Several Strategies," Maritime Economics & Logistics, Palgrave Macmillan;International Association of Maritime Economists (IAME), vol. 7(1), pages 19-35, March.
    19. Adland, Roar & Cullinane, Kevin, 2006. "The non-linear dynamics of spot freight rates in tanker markets," Transportation Research Part E: Logistics and Transportation Review, Elsevier, vol. 42(3), pages 211-224, May.
    20. Sødal, Sigbjørn & Koekebakker, Steen & Aadland, Roar, 2008. "Market switching in shipping -- A real option model applied to the valuation of combination carriers," Review of Financial Economics, Elsevier, vol. 17(3), pages 183-203, August.
    21. Schwartz, Eduardo S, 1997. "The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging," Journal of Finance, American Finance Association, vol. 52(3), pages 923-973, July.
    22. Helen Bendall & Alan F. Stent, 2003. "Investment strategies in market uncertainty," Maritime Policy & Management, Taylor & Francis Journals, vol. 30(4), pages 293-303, October.
    23. Sarkar, Sudipto, 2003. "The effect of mean reversion on investment under uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 28(2), pages 377-396, November.
    24. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, vol. 73(1), pages 228-233, March.
    25. Bar-Ilan, Avner & Strange, William C., 1996. "Urban Development with Lags," Journal of Urban Economics, Elsevier, vol. 39(1), pages 87-113, January.
    26. Veenstra, Albert Willem & Franses, Philip Hans, 1997. "A co-integration approach to forecasting freight rates in the dry bulk shipping sector," Transportation Research Part A: Policy and Practice, Elsevier, vol. 31(6), pages 447-458, November.
    27. Steen Koekebakker & Roar Adland & Sigbjørn Sødal, 2006. "Are Spot Freight Rates Stationary?," Journal of Transport Economics and Policy, University of Bath, vol. 40(3), pages 449-472, September.
    28. Bhattacharya, Sudipto, 1978. "Project Valuation with Mean-Reverting Cash Flow Streams," Journal of Finance, American Finance Association, vol. 33(5), pages 1317-1331, December.
    29. Ying Kou & Meifeng Luo & Yifei Zhao, 2018. "Examining the theoretical–empirical inconsistency on stationarity of shipping freight rate," Maritime Policy & Management, Taylor & Francis Journals, vol. 45(2), pages 145-158, February.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Tvedt, Jostein, 2019. "Transport services and the valuation of flexibility over business cycles," Transportation Research Part A: Policy and Practice, Elsevier, vol. 130(C), pages 517-528.
    2. Fan, Lixian & Li, Ziyan & Xie, Jiaqi & Yin, Jingbo, 2023. "Container ship investment Decisions―Newbuilding vs second-hand vessels," Transport Policy, Elsevier, vol. 143(C), pages 1-9.
    3. Fan, Lixian & Gu, Bingmei & Yin, Jingbo, 2021. "Investment incentive analysis for second-hand vessels," Transport Policy, Elsevier, vol. 106(C), pages 215-225.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Andrianos Tsekrekos, 2013. "Irreversible exit decisions under mean-reverting uncertainty," Journal of Economics, Springer, vol. 110(1), pages 5-23, September.
    2. Tsekrekos, Andrianos E., 2010. "The effect of mean reversion on entry and exit decisions under uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 34(4), pages 725-742, April.
    3. Bulan, Laarni & Mayer, Christopher & Somerville, C. Tsuriel, 2009. "Irreversible investment, real options, and competition: Evidence from real estate development," Journal of Urban Economics, Elsevier, vol. 65(3), pages 237-251, May.
    4. Caren Sureth, 2002. "Partially Irreversible Investment Decisions and Taxation under Uncertainty: A Real Option Approach," German Economic Review, Verein für Socialpolitik, vol. 3(2), pages 185-221, May.
    5. Jostein Tvedt, 2022. "Optimal Entry and Exit Decisions Under Uncertainty and the Impact of Mean Reversion," SN Operations Research Forum, Springer, vol. 3(4), pages 1-21, December.
    6. Sødal, Sigbjørn & Koekebakker, Steen & Aadland, Roar, 2008. "Market switching in shipping -- A real option model applied to the valuation of combination carriers," Review of Financial Economics, Elsevier, vol. 17(3), pages 183-203, August.
    7. Bouasker, O. & Letifi, N. & Prigent, J.-L., 2016. "Optimal funding and hiring/firing policies with mean reverting demand," Economic Modelling, Elsevier, vol. 58(C), pages 569-579.
    8. Lander, Diane M. & Pinches, George E., 1998. "Challenges to the Practical Implementation of Modeling and Valuing Real Options," The Quarterly Review of Economics and Finance, Elsevier, vol. 38(3, Part 2), pages 537-567.
    9. Sigbjørn Sødal & Steen Koekebakker & Roar Aadland, 2008. "Market switching in shipping — A real option model applied to the valuation of combination carriers," Review of Financial Economics, John Wiley & Sons, vol. 17(3), pages 183-203, August.
    10. Ali Al-Aradi & Alvaro Cartea & Sebastian Jaimungal, 2018. "Technical Uncertainty in Real Options with Learning," Papers 1803.05831, arXiv.org, revised Jul 2018.
    11. Rau, Philipp & Spinler, Stefan, 2016. "Investment into container shipping capacity: A real options approach in oligopolistic competition," Transportation Research Part E: Logistics and Transportation Review, Elsevier, vol. 93(C), pages 130-147.
    12. Abadie, Luis M. & Chamorro, José M., 2008. "Valuing flexibility: The case of an Integrated Gasification Combined Cycle power plant," Energy Economics, Elsevier, vol. 30(4), pages 1850-1881, July.
    13. Sarkar, Sudipto, 2003. "The effect of mean reversion on investment under uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 28(2), pages 377-396, November.
    14. Marcel Philipp Müller & Sebastian Stöckl & Steffen Zimmermann & Bernd Heinrich, 2016. "Decision Support for IT Investment Projects," Business & Information Systems Engineering: The International Journal of WIRTSCHAFTSINFORMATIK, Springer;Gesellschaft für Informatik e.V. (GI), vol. 58(6), pages 381-396, December.
    15. repec:dau:papers:123456789/1046 is not listed on IDEAS
    16. Haehl, Christian & Spinler, Stefan, 2020. "Technology Choice under Emission Regulation Uncertainty in International Container Shipping," European Journal of Operational Research, Elsevier, vol. 284(1), pages 383-396.
    17. Chuang-Chang Chang & Miao-Ying Chen, 2012. "Re-examining the investment-uncertainty relationship in a real options model," Review of Quantitative Finance and Accounting, Springer, vol. 38(2), pages 241-255, February.
    18. Gryglewicz, Sebastian & Huisman, Kuno J.M. & Kort, Peter M., 2008. "Finite project life and uncertainty effects on investment," Journal of Economic Dynamics and Control, Elsevier, vol. 32(7), pages 2191-2213, July.
    19. Juri Hinz & Tanya Tarnopolskaya & Jeremy Yee, 2020. "Efficient algorithms of pathwise dynamic programming for decision optimization in mining operations," Annals of Operations Research, Springer, vol. 286(1), pages 583-615, March.
    20. Glover, Kristoffer J. & Hambusch, Gerhard, 2016. "Leveraged investments and agency conflicts when cash flows are mean reverting," Journal of Economic Dynamics and Control, Elsevier, vol. 67(C), pages 1-21.
    21. Taschini, Luca, 2021. "Flexibility premium of emissions permits," Journal of Economic Dynamics and Control, Elsevier, vol. 126(C).

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:transa:v:118:y:2018:i:c:p:714-729. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/wps/find/journaldescription.cws_home/547/description#description .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.