Income uncertainty and the decision to invest in bulk shipping

• Author: Panos K. Pouliasis,Nikos C. Papapostolou,Nikos K. Nomikos,Ioannis Kyriakou
• Published date: 01 June 2018
• Date: 01 June 2018
• DOI: http://doi.org/10.1111/eufm.12132

DOI: 10.1111/eufm.12132

ORIGINAL ARTICLE

Income uncertainty and the decision to invest in

bulk shipping

Ioannis Kyriakou

|

Panos K. Pouliasis

|

Nikos C. Papapostolou

|

Nikos K. Nomikos

Cass Business School, City, University of

London, 106 Bunhill Row, London EC1Y

8TZ, UK

Emails: ioannis.kyriakou@city.ac.uk;

p_pouliasis@city.ac.uk;

n.papapostolou@city.ac.uk;

n.nomikos@city.ac.uk

Abstract

We develop a coherent framework for the valuation of real

assets and determination of the optimal time to invest. To

this end, we model the stochastic nature of income and

develop methodologies for valuing traded derivatives to

facilitate model calibration. A valuation paradigm for

freight-linked assets is then presented and, using a real

option approach, we demonstrate its usefulness in invest-

ment appraisal and optimal timing of entry in the shipping

industry. We find that long-run freight rate and volatility

have an impact on the decision timing and value of the

investment that diminishes with increasing vessel age. As

time to build declines, the value of the option to wait

increases implying a high opportunity cost embedded in the

investment decision due to construction lags.

KEYWORDS

contingent claims, investment, real options, shipping, uncertainty

JEL CLASSIFICATION

C13, C63, G13, G31, L92

We would like to thank theManaging Editor John A. Doukas and two anonymous refereesfor their constructive comments

and suggestions. The paper in its currentform has been presented at the Finance & Stochastics seminars of the University of

Sussex, the 5th NUS Workshop on Risk & Regulation(5th Rˆ2 Workshop 2017) in Singapore, the 2nd Symposiumon

Quantitative Financeand Risk Analysis (QFRA 2016) in Rhodes, and the Spring2016 Conference of the Multinational

Finance Society in Cyprus. Earlierversions of the paper have been presented at the Annual Conference of the International

Association of Maritime Economists (IAME 2015) in Malaysia and the 1st Symposiumon Quantitative Financeand Risk

Analysis (QFRA 2015) in Santorini.We thank all participants for useful feedback. All remaining errorsare of course our own.

Eur Financ Manag. 2018;24:387–417. wileyonlinelibrary.com/journal/eufm © 2017 John Wiley & Sons, Ltd.

|

387

1

|

INTRODUCTION

Investment timing and uncerta inty are issues that call for care ful consideration when commit ting to

any investment. Managers rely e xtensively on the use of traditiona l investment valuation criteria

such as the internal rate of retur n (IRR) and net present value (NPV) . These methods, although

intuitive and easy to implement ,ha ve their shortcomings as the managerial flexibility im plicit in any

investment opportunity, that is , the option to adapt investment decision s in response to uncertainty,

is not taken into account, result ing in suboptimal investment ti ming rules. As such, managers of ten

ignore or underestimate the ex tent of uncertainty and its implic ations. This can be dealt with by

treating the investment dec ision as the exercise of an optio n under uncertainty, in which c ase real

option theory provides bette r answers. In their seminal paper, B rennan and Schwartz (1985)

evaluate natural resource inve stments based on arbitrage argu ments, where uncertainty orig inates

from the output price; oper ational policy decisions, s uch as postponing productio n temporarily or

permanently, are also exam ined. Other early contribu tions on the use of real option th eory in

evaluating investment proj ects include McDonald and Sie gel (1986), Majd and Pindyck (19 87),

Dixit (1989), Triantis and Hodde r (1990), and Pindyck (1991); we refer to Dixit and Pindyck (1994)

for a comprehensive litera ture survey. Typically, the payoff of the call op tion is a convex function of

the underlying random variabl e, thus its value increases with un certainty, that is, the greater the

uncertainty the greater the va lue of the option to invest and, hence, the ince ntive to keep the option

open;

1

the investment decision is affe cted by the assessment of the option to ei ther invest

immediately or wait and observ e the progress of the investment unti l market conditions improve.

Hitherto, this is an issue that has been explore d, inter alia, in different investme nt projects such as

real estate (Grenadier, 1996 ), environmental technologie s (Cortazar, Schwartz, & Salin as, 1998),

natural resources (Kellogg , 2014; Moel & Tufano, 2002; Schwartz & Smith, 2000), and infor mation

technology (Schwartz & Zozay a-Gorostiza, 2003).

This paper focuses on deep-sea shipping. This industry lends itself to this analysis as it is the

backbone of international trade −80% of global trade by volume and 70% of global trade by value

are carried by sea and handled by ports (United Nations Conference on Trade and Development

[UNCTAD], 2015) –and a leading indicator of the global economy (Kilian, 2009) that has

recently attracted much interest also in the finance and economics literature (e.g., see

Kalouptsidi, 2014; Papapostolou, Nomikos, Pouliasis, & Kyriakou, 2014). Furthermore, the

valuation of vessels has been traditionally based on the price that a well-informed rational

investor would pay for the acquisition of a vessel using conventional investment criteria such as

NPV. However, this static framework is unable to capture the market dynamics and the strategic

optionalities available to shipping investors, such as the commitment of time and capital

resources to order a vessel.

The key contribution of this paper is the development of a framework for evaluating real assets

(ships in this case) and investing based on a real-option-based approach. The methodology is applied to

the drybulk sector of the shipping industry which provides an ideal framework for empirical testing as

there are numerous strategic and managerial flexibilities embedded in shipping investment and

operation decisions (Alizadeh & Nomikos, 2009). Within this framework, two innovations are

proposed. First, we derive a new, fast, and accurate analytical method for pricing traded contingent

1

An exception to this rule is identified in Kandel and Pearson (2002), who find that a negative relation may exist between

the value of real options and uncertainty in the case of an incremental investment in technology aimed at reducing marginal

costs of production.

388

|

KYRIAKOU ET AL.