Investment in Next Generation Networks and the Role of Regulation: A Real Option Approach



4. - A model to evaluate investment in NGNs.

This paragraph aims at identifying a model for evaluating call options for which
premature exercise may be optimal, which captures best the characteristics of the
investment in next generation networks by telecommunication operators19.

In order to apply a real option approach to investments we assume the existence of an
asset or of a dynamic portfolio of assets which is perfectly correlated with the investment
net cash. The firm’s ability to defer an irreversible investment is akin to an American call
option. The financial option parallel arises from the fact that the firm has the opportunity -
but not the obligation - to undertake an investment at some future moment in time.

In real life managers evaluate investments opportunities on a monthly or quarterly basis.
Therefore, models which allow the exercise of the option (and the evaluation of its
optimality) at a certain pre-specified (equally spaced) dates reflect business reality better
than those framed in continuous time settings: these are known as Bermudan options, since
they lie in between American options (which can be exercised continuously) and European
ones (which can be exercised only at expiry).

In the telecommunication industry, there is still an enormous uncertainty surrounding the
returns on services based on NGNs, as stressed at the outset of the paper. Clearly such
services cannot be the same as the current ones based on DSL or similar technologies: if
this were the case, there would be little point in incurring a massive disbursement such as
the one required by NGNs, whereas operators could upgrade their network incrementally in
order to reach higher speed and better quality of service20. Hence NGN services and their
prices are still clouded by a vast amount of uncertainty.

Based on past experience, the main uncertainties regarding the project revenues and cost
savings would typically unveil themselves within five to seven years from the emergence of
the business opportunity. After a certain number of years, the volatility can become so

19 In the last decades the literature on financial option focusing on valuing call options for which premature
exercise may be optimal has been abundant. For a brief presentation of the various techniques and approaches
available see Gekse and Shastri (1985).

20 In certain areas where the telecommunications copper network encounters serious bottlenecks or congestion
issues, it may be theoretically convenient to invest in NGNs due to the cost savings brought about by the
optical fibre, rather than upgrade the existing network. However these case seem very limited in scope.

22



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