Real Option Pricing Model Applied to Industrial and Regional Benefits Policy

Abstract

This research intends to inform policy discussion on the subject of Aerospace and Defence sector procurement strategies at Industry Canada (IC). Specifically, this research explores procurement strategies in terms of a real option pricing model that move toward a novel use of Industrial and Regional Benefits (IRB) policies in promoting sector-specific, innovation-driven growth. It is further hypothesized that IRB obligations can be better tailored to encourage value adding activities within prime contractors' supply chains (typically small and medium enterprises in this sector). This research focusses on the novel development of a decision support tool using a theory of option pricing for derivatives whose returns fluctuate according to a power law distribution. This tool is shown to provide guidance to assist in adequately rewarding prime contractors who invest in innovative activities while fulfilling their IRB obligations.