**Research**

## Published articles

**A Real Option Analysis on Retiring Existing Coal-fired Electricity Plants in the United States**

Kang, Sang Baum, Pascal Létourneau, and Steven X. Sala (2018)

*Journal of Energy Markets*

To reduce CO2 emissions from the electricity generation sector, the U.S. introduced the Clean Power Plan (CPP) in 2015. Specifically, building block #2 aimed to replace coal-fired electricity generation with natural gas-fired generation. In 2017, the U.S. federal government decided not to honor the U.N.’s Paris Agreement, and repealed the CPP. In this paper, we study the conditions under which a reasonable green policy by a state encourages the early replacement of existing coal plants with new natural gas plants, as CPP building block #2 suggested. Using a real option model, we calculate the probability that a firm makes an investment decision to retire an existing coal plant and build a new natural gas plant within the next few years. We find that the results critically depend on the remaining useful life of the existing coal plant. When the remaining life is short, government policies do not play a significant role in this asset replacement decision. However, if the remaining useful life is approximately 20+ years, a state government’s green policy does plays a significant role in the plant’s replacement. Because such plants were built during the “coal plant boom” period from 1965 to 1987, our findings are particularly relevant.

**Is it still economic to build a new coal-fired power plant in the U.S.? A real option analysis**

Kang, Sang Baum, Pascal Létourneau, and Steven X. Sala (2018)

*Applied Economics Letters*

In the U.S., virtually no new coal-fired power plants have been built in recent years. Both industry experts and academics seem to believe that no rational firm will build a new coal-fired plant. Will such a trend continue in the future? To provide insights into this question, we investigate the optimal decision of an electricity company with an irreversible and deferrable opportunity to build either a new coal-fired or natural gas-fired power plant as its new base-load resource. According to our real option analysis, the optimal decision depends on the location. In the case of the eastern U.S., it is optimal to choose a natural gas plant if a firm is given a choice among a new natural gas plant, a new coal plant and deferring the investment. However, contrary to the common sentiment in the industry and academia, building a new coal plant in the western U.S. is still more economical than building a new natural gas plant in the absence of emission pricing. Furthermore, introducing carbon pricing to western U.S. states, as California did, can substantially increase the probability that a firm will optimally choose a natural gas plant over a coal plant.

**The Model-Free Equivalence Condition for American Spread Options**

Kang, Sang Baum, and Pascal Létourneau (2017)

*Theoretical Economics Letters,*

*7*(04), 757

A spread option involves the right to obtain the spread between two asset prices at a predefined strike price. This type of derivative security is frequently used in financial markets and academic finance. Furthermore, analysts use the spread option technique for real option modeling purposes. Some spread options are American-type in the sense that an option holder may exercise her option prior to the expiration. In this paper, we propose an equivalence condition for American spread options under which they are not exercised early, and are therefore equivalent to European options. Our theoretical results, developed within a model-free economic setting, suggest that the equivalence conditions documented by previous papers do not hold in a distribution-free environment. Traders , quantitative modelers, and financial programmers in various derivatives markets and the real option modeling area may use our results.

**Investor’s Reaction to the Government Credibility Problem: A Real Option Analysis of Emission Permit Policy Risk.**

Kang, Sang Baum, and Pascal Létourneau (2016)

*Energy Economics,*54: 96-107

In relation to creating a CO2 emission permit market, there are two types of climate change policy risks: 1) It is uncertain whether and when a cap-and-trade system will be implemented; and 2) once a policy is in place, there may be government credibility issues. This paper examines the effect of these policy risks on real option decisions of electric power plant investment. To model both an investment decision and generation flexibility, this study evaluates an exotic compound American option on multiple strips of European spread options through the implementation of least squares Monte-Carlo simulation. Government credibility risk leads to more investment in “less green” resources and induces additional cash flow variation, which increases the average time to investment (value of waiting). However, in an extreme case, government credibility can actually hasten investment because the risk may be more favorable to electric power companies. Furthermore, if emission trading is planned to be implemented in the future (e.g., 2020), and the market believes that the probability of successful implementation is low, firms will build a “less green” plant early to benefit from the period before the green rule is applied..

**Refining the Least Squares Monte Carlo Method by Imposing Structure.**

Létourneau, Pascal, and Lars Stentoft (2014)

*Quantitative Finance*14.3 (2014): 495-507.

The least squares Monte Carlo method of Longstaff and Schwartz (2001) has become a standard numerical method for option pricing with many potential risk factors. An important choice in the method is the number of regressors to use and using too few or too many regressors leads to biased results. This is so particularly when considering multiple risk factors or when simulation is computationally expensive and hence relatively few paths can be used. In this paper we show that by imposing structure in the regression problem we can improve the method by reducing the bias.

## Under review

**This is how you make a GARCH smile - A new estimation method for the NGARCH model**.

Letourneau, Pascal

(under review since November 2017)

This paper proposes an improved estimation method to Engle and Ng's (1993) NGARCH(1,1) model. The proposed estimator fixes one parameter such that the unconditional kurtosis of the NGARCH model matches the sample kurtosis, solving the problem raised by Bai et al. (2003). The method can be used to estimate on historical returns, calibrate on observed option prices, or both at the same time. First, the estimation time is cut by more than 50%, without sacrificing the quality of the fit. Second, these estimates offer better performance when pricing options out of sample. Third, the calibration time is cut by a factor of two without sacrificing the quality of the fit.

**Improved Greeks for American Options Using Simulation.**

Letourneau, Pascal, and Lars Stentoft

(under review since May 2018)

This paper revisits the estimation and approximation of the Greeks for American style options and compares various methods in term of bias, convergence and overall performance. Using the constrained least squares Monte Carlo method of Létourneau and Stentoft (2014) a new, simple and computationally efficient method is proposed, which is based on differentiating the holding value function. The proposed method is shown to perform well compared to existing methods.

**Real Options' Exercise Probability and Timing**

**.**

Kang, Sang Baum, and Pascal Létourneau

(Working paper)

A critical difference between real options and financial options lies in that real option holders, writers, and even external stakeholders can modify the characteristics of real options to increase or decrease its exercise probability. One may adjust the strike price, or the level and risk of the underlying process. Using general quantile-preserving spreads to model risk, this paper shows under which conditions an increase in risk may increase the exercise probability and hasten real option exercise. This paper significantly generalizes previously obtained results. The results are useful to determine an optimally parsimonious modification of a real option to increase or decrease its exercise probability and have policy implications.

## Projects

**Evidence of inflation risk pricing in US stock market**

Pascal Létourneau, Garrett Smith

(Working paper)

This paper studies how investors considers the inflation risk in their stock pricing.

**Efficient valuation of American Options**

**.**

Pascal Létourneau, Lars Stentoft

(Working paper)

This paper proposes an efficient method to simultaneously price and compute hedge ratios of a large portfolio of American options.