Risk-Neutral Pricing Approach for Evaluating BOT Highway Projects with Government Minimum Revenue Guarantee Options

Abstract

Build-operate-transfer (BOT) is a public-private partnership (PPP) project delivery system for the financing, development, and operations of highway projects around the world. Uncertainty about future traffic demands is one of the most important risk factors in the operations phase of a BOT project. There is a considerable amount of evidence indicating that the improper consideration of this uncertainty contributes to the financial failure of BOT projects. The inherent limitation of conventional economic analysis methods contributes to this uncertainty; most notably the net present value (NPV) approach that is typically used in the economic valuation of BOT projects. In addition, the NPV approach is insufficient to determine the correct market value of minimum revenue guarantee (MRG) options. The government offers MRG options to the concessionaire as a revenue risk-sharing strategy in BOT projects. The authors apply the real options theory from finance/decision science to explicitly price MRG options in BOT projects. This real options model has several prominent attributes that make it different from NPV models. It uses a market-based option pricing approach called risk-neutral valuation method to determine the correct value of MRG options. Unlike the other models, this approach treats the risk of underestimating future traffic demands internally and adjusts for the traffic market risk in the valuation of MRG options. The authors’ approach also describes a procedure for characterizing the concessionaire’s economic risk profile under uncertainty about future traffic demands. In addition, it uses real options analysis to price MRG and traffic revenue cap (TRC) options as compound options and determines their effects on the concessionaire’s economic risk profile. The probability distributions of when the concessionaire may request MRG and when the public sector may receive additional revenues as TRC options are also presented. Further, the distributions of the number of times that the concessionaire may request the MRG option and the number of times that the public sector may receive additional revenue are characterized. Finally, this model identifies the probability distributions of the present value of MRG options and the present value of total additional revenues recalled by the public sector. The proposed model can help public and private sectors better analyze and understand the economic risk of BOT projects under uncertainty about future traffic demands. The private sector can use this proposed model to make better entry decisions to BOT highway projects considering the level of support provided by the government. The government can also use this proposed model to identify the appropriate MRG levels to encourage private investments without comprising future budgetary strength.