MFE 230 L

Real Options and Commodity Derivatives

Instructor: Professor Jonathan Berk

Office: F634

Phone: 642-3364

Email: berk@haas.berkeley.edu

WWW: http://faculty.haas.berkeley.edu /berk

Office Hours: TBA and by appointment

GSI: Nigel Barradale (nigel@haas.berkeley.edu)

This course will use recent advances in real option theory to value a wide range of phenomenon. These include the “convenience yield” in commodity futures prices, the value of pure growth firms (firms with no current earnings), the optimal time for a firm to invest or liquidate, and valuing and optimally undertaking staged investment decisions. The course will also introduce students to recent advances in theoretical asset pricing models that use an option based approach to value a firm based on its fundamentals. Both derivative courses are a prerequisite for this course.

Required Texts: Course Packet

Investment Under Uncertainty by A. Dixit and R Pindyck (DP)

Optional Reading: The Economist, New York Times, Wall Street Journal, Financial Times

There really is no textbook that has been written for this course. I decided to assign Dixit and Pindyck because it will be a very useful reference for those of you who have forgotten the material you learned in the derivative courses. When I do assign specific chapters, I use the shorthand DP on the syllabus.

Class Meeting Times: Please consult the accompanying document Schedule of Classes to find out when we will meet. We will meet for a total of 30 hours. However, given the nature of the course, we will not necessarily meet regularly. In general we will try to meet for 3 hours and we will always leave at least a two day break between a theory lecture and the accompanying case discussion. This will allow you enough time to digest the theory so you can use it to solve the case. Sometimes this will necessitate having a 1½ hour lecture.

Reading and Case Preparation: You should always reinforce the lectures by doing the assigned readings. Thoroughly preparing for all case discussions is a requirement of this course. The purpose of the MFE degree is not primarily to train you technically, but rather to teach you how to apply your technical skills. I view the case component of this course as more important than the theoretical component. As you will see below, 20% of your grade will be determined by your performance during class during case discussion. All students should be thoroughly prepared for every case discussion. I will cold call extensively during case discussions.

Group Work: You may prepare for the lectures together. You can also do the assignments and case summaries in a group of no more than 4 students. Each group should hand in only one deliverable with the contributing group members clearly indicated. However, you may not work with the same group on the case summaries and the assignments. If any two class members work in the same group for the case summaries and assignments, I will reduce both member’s grades by one full letter.

Class Homepage: You will find additional material that should be useful on my homepage. A copy of the lecture notes will be posted on this page on the day of the given lecture. All material that is handed out during the lecture will also be available on this homepage.

Email: I am also always reachable by email. If you have questions, feel free to email them to me. In some cases I will distribute the answer to the whole class.

Other Deliverables: You will see from the attached syllabus that there are two assignments due during the course of the semester. The first assignment is due February 15, the second is due by the last class. In addition, a short summary (1 or 2 pages) of each case marked in boldface in the syllabus is due at the beginning of each case discussion. These summaries should contain a short description of your group’s solution of the case as well as the evidence you used to support your conclusion. The summaries will be graded on a pass/fail basis.

Grades: Your final grade will be determined by the quality of your classroom participation and your group’s performance on the case summaries and assignments.

Classroom Participation 20%

Assignments 50%

Case Summaries 30%

Course Syllabus

Here is a list of topics. Please consult the schedule of classes to find out when each topic will be covered.

Note: Readings from the required text (Dixit and Pindyck) are labeled DP. Cases in boldface require that a summary be handed in at the beginning of the class when the case is discussed.

Introduction

(i) Reading:

“Keeping all options open” (Economist, August 14, 1999)

(iI) Case Study

Arundel Partners

HBS Case

Commodities

Commodity Derivatives

(i) Reading:

Schwartz: “The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging”

Cox, Ingersoll and Ross: “The Relation Between Forward Prices and Futures Prices”

(ii) Case Studies

Enron Gas Services

HBS Case

Metallgesellschaft

Culp and Miller: “Mettalgesellschaft and the Economics of Synthetic Storage”

Mello and Parsons: “Maturity Structure of a Hedge Matters: Lessons from the Metallgesellschaft Debacle”

Brennan and Crew: “Hedging Long Maturity Commodity Commitments with Short-Dated Futures Contracts.”

The Gold Enigma

(i) Reading:

Brennan: “Latent Assets”

Borenstein: “Why do Gold Mining Companies Mine Gold? A Puzzle

Economic Models of the Convenience Yield

(i) Reading:

Deaton and Laroque: “On the Behavior of Commodity Prices”

Routledge, Seppi and Spatt: “Equilibrium Forward Curves for Commodities”

(ii) Assignment --- Due February 15.

You will investigate, using the available data, whether or not this is something to worry about.

Real Options

Investment Under Uncertainty --- The Basics

(i) Reading:

DP: Chapters 1 and 2

Berk and DeMarzo: Chapter 21

(ii) Case Study

Interest Rate Uncertainty

Berk: “A Simple Approach for Deciding When to Invest”

Value of a Project and the Decision to Invest

(i) Reading:

DP: Chapter 6

(ii) Case Study

MW Petroleum Corp.

HBS Case

Entry and Exit

(i) Reading:

DP: Chapter 7

(ii) Case Study

Evaluating Natural Resource Investments

Brennan and Schwartz: “Evaluating Natural Resource Investments”

Competition

(i) Reading:

DP: Chapter 8

Grenadier: “Option Exercise Games: An Application to the Equilibrium Investment Strategies of Firms”

Novy-Marx: “An Equilibrium Model of Investment Under Uncertainty”

(ii) Case Study

Bidding for Antimina

HBS Case

Applications in Corporate Finance

Rules of Thumb

(i) Reading:

McDonald, Robert, Real Options and Rules of Thumb in Capital Budgeting in M. J. Brennan and L. Trigeorgis (eds.), Project Flexibility, Agency, and Competition (London, Oxford University Press, 2000).

(ii) Assignment --- Due March 13

How well do the rules of thumb work?

Firm Valuation

(i) Reading:

Berk, Green and Naik: “Optimal Investment, Growth Options and Security Returns”

Valuing Growth

(i) Reading:

DP: Chapter 10

Berk, Green and Naik: “Valuation and Return Dynamics of New Ventures”

(ii) Case Study:

Hsu and Schwartz: “A Model of R&D Valuation and the Design of Research Incentives”

U.S. Integrated Optics