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To cite this article: Sabry A. Abdel Sabour & Richard Poulin (2006) Valuing Real
Capital Investments Using The Least-Squares Monte Carlo Method, The Engineering
Economist: A Journal Devoted to the Problems of Capital Investment, 51:2, 141-160
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The Engineering Economist, 51: 141–160
Copyright © 2006 Institute of Industrial Engineers
ISSN: 0013-791X print / 1547-2701 online
DOI: 10.1080/00137910600705210
Richard Poulin
INTRODUCTION
ments. The failure to address the management responses to the cyclic price
movements will result in inaccurate estimates and consequently will lead
to wrong decisions.
Unlike the NPV method, the real options approach (ROA) can deal effi-
ciently with the issue of management flexibility to alter or revise decisions
when the uncertainty about some key variables is resolved. As explained by
Miller and Park (2002), while the discounted cash flow analysis is applica-
ble only to projects with low payoff volatility, the ROA is applicable to most
projects due to its efficiency to handle the high volatility that characterizes
the real investment projects. The growing list of ROA applications includes:
R&D industries, technology investments, natural resource industries, and
manufacturing and inventory projects (see Trigeorgis (1996); Miller and
Park (2002) for more details and references).
The methods for valuing options can be divided into analytical and
numerical methods. The first analytic model for valuing simple financial
options was developed by Black and Scholes (1973). Following Black
and Scholes, the research has been directed to develop numerical methods
capable to deal with the issue of valuing complex options such as the
American-type options with multiple uncertain state variables.
The most widely known numerical techniques for valuing options are:
finite difference (see Shwartz (1977); Brennan and Schwartz (1977, 1978),
binomial lattice (see Cox et al. (1979)), and Monte Carlo simulation (de-
veloped by Boyle (1977)). The most important drawback of both finite
difference and lattice methods is that they are impractical for valuing com-
plex options with multiple uncertain state variables. As explained by Grant
et al. (1997), both finite difference and lattice methods can only be applied
for valuing options with a few uncertain state variables. Also, Barraquand
and Martineau (1995) argued that both finite difference and binomial lat-
tice methods suffer the curse of dimensionality when applied for valuing
options with more than two assets since the level of complexity grows
exponentially with the number of underlying assets. In contrast to both
the finite difference and lattice methods, Monte Carlo simulation can deal
Valuing Real Capital Investments 143
efficiently with the situations where there are multiple and complex stochas-
tic variables. In the Monte Carlo method, the value of an option is deter-
mined by simulating sample paths for the stock price, determining the
option payoff in each path, and then discounting at the risk-free rate and
averaging by the number of simulated paths.
Until recently, there was a general belief that since Monte Carlo simula-
tion is a forward induction technique, it cannot deal with the early exercise
feature of American options and accordingly it is applicable only for valu-
ing European options (Hull and White, 1993). Tilley (1993) was the first
researcher to propose a modification to Monte Carlo simulation in order to
make it applicable for valuing American options. As explained by Boyle
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et al. (1997), the main drawbacks of Tilley’s algorithm are that the estima-
tor tends to be biased high and it is difficult to apply it for valuing options
with multiple state variables. To overcome this problem, Barraquand and
Martineau (1995) proposed the stratified state aggregation in which the op-
tion payoff space is partitioned instead of the stock price space. Although
Barraquand and Martineau’s approach can value American securities with
multiple state variables, it tends to undervalue options since its exercise pol-
icy is not the optimal one (Boyle et al., 1997). Carriere (1996) provided a
sequential regression algorithm in which the optimal early exercise policy
is determined by estimating the conditional expectations using nonpara-
metric regression techniques. Compared to Tilley’s algorithm, the method
proposed by Carriere is less biased, but there is also a debate about its
applicability to value multi-factor American options.
In an attempt to reduce the bias and extend Monte Carlo simulation
method to the cases where there are multiple state variables, Broadie
and Glasserman (1997) proposed a different simulation algorithm that
combines the Monte Carlo method with the decision-tree technique. As
demonstrated by Grant et al. (1997), the main drawback of Broadie and
Glasserman’s algorithm is that because the quantity of data increases ex-
ponentially with the number of early exercise dates, it is impractical for
applications that require dividing the time to maturity into a large number
of early exercise dates. Longstaff and Schwartz (2001) proposed a simple
method for valuing American options using Monte Carlo simulation based
on least-squares method. The advantages of the proposed least-squares
Monte Carlo (LSM) method over the other proposed simulation techniques
are that it is simple, requires less computational time, and can be applied to
value complex options with many underlying stochastic variables. Tsitsiklis
and Van Roy (2001) proposed a similar regression-based method for valu-
ing American-style options using simulation. Different from the method
proposed by Longstaff and Schwartz (2001), the method is based on approx-
imating the value function directly using a linear combination of known
basis functions.
144 S.A.A. Sabour and R. Poulin
where H is the exercise price of the put option and S(w,T) is the stock price
at maturity along the path w.
At any early exercise time tk < T, if the option is in the money, the
optimal exercise policy is determined by comparing the immediate exercise
payoff with the expected continuation value. The immediate exercise value
along the path w is simply the difference between the exercise price H
and the stock price S(w,tk ). Under the risk-neutral pricing measure Q, the
expected continuation value F(w;tk ) based on the information β at time tk
assuming that the option is not exercised until after tk and the option holder
following the optimal stopping strategy for all x, tk < x ≤ T is
tj
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K
F(w; tk ) = E Q exp − r (w, x)d x C(w, t j ; tk , T ) βtk (2)
j=k+1
tk
where C(w,tj ;tk ,T) is the remaining cash flows and r(w,x) is the risk-free
discount rate.
The least-squares regression is applied to estimate the conditional expec-
tation function at tK−1 , tK−2 , . . . , t1 assuming that the unknown functional
form of F(w;tk ) can be approximated by a linear combination of M ba-
sis functions Lj (S) such as Laguerre polynomials, trigonometric series, or
simple powers of the stock price S such as
M
F(w; tk ) = a j L j (S) (3)
j=0
decisions at each exercise date along all the paths are determined, the value
of the option is estimated by discounting the cash flows to time 0 at the
risk-free rate and averaging over the number of paths N.
Although Monte Carlo simulation method is easy to implement and can
handle complex stochastic processes, its main disadvantage is the vari-
ance of the estimate. However, as explained by Boyle et al. (1997), using
the variance reduction techniques, such as the control variate, the anti-
thetic variate, moment matching, importance sampling, conditional Monte
Carlo, low-discrepancy sequences, and quasi-random sequences, can sub-
stantially reduce the variance of the estimate. Also, Moreni (2004) proposed
a variance reduction technique based on importance sampling by means of
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the mine when it is open (V̂o ) and when it is closed (V̂c ) can be estimated
conditional on the simulated metal price S at each path. The optimum
operating mode at each time step is determined by comparing the expected
values of the mine in the three operating modes. If V̂o is less than V̂c minus
the shutting cost (Cc ), the mine should be closed. If V̂c is less than V̂o
minus the reopening cost (Co ), the mine should be reopened. Otherwise, if
the value of the mine in the current mode is less than the abandonment cost,
the mine is abandoned. According to this dynamic process, the value of the
mine in the open mode is the maximum of; V̂o , V̂c − Cc , and Va , and the
value of the mine in the shutting mode is the maximum of; V̂c , V̂o − Co , and
Va . After determining the optimum operating modes and the corresponding
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revised cash flows at each time step throughout all the paths, the mine
value is estimated by discounting the cash flows at the risk-free rate and
averaging over the number of paths. A Matlab-based program is developed
by the authors for conducting the mine valuation using the LSM method.
In this section, the accuracy of the LSM method will be tested by comparing
its valuation results for a hypothetical copper property with the valuation
results generated by finite difference technique. Table 1 shows the given
data for the hypothetical copper mine as presented in Brennan and Schwartz
(1985).
Based on the data given in Table 1, the 150 million pounds inventory
(Q) are sufficient for 15 production years at an annual rate (q) of 10 million
Table 1. Given data for a hypothetical copper mine (Brennan and Schwartz,
1985)
Item Description Item Description
pounds. Assuming full loss offset, as in Brennan and Schwartz (1985), the
annual cash flow components are estimated as follows:
Revenue = qS
Operating costs = qa
Royalty = t1 qS
Income taxes = t2 q[S(1-t1 )-a]
Net cash flow = Revenue − Operating costs − Royalty − Income taxes
The real state tax rate (t3 ) represents the property tax rate on the value of
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the mine. With the flexibility model of Brennan and Schwartz (1985), the
management has the option to optimally revise the mine status according
to the copper price level. With this flexibility, the management can close
the mine temporarily in response to the low copper price level. In this case,
a $0.2m closing cost (Cc ) will be incurred and an annual maintenance cost
(Cm ) of $0.5m will be spent for maintaining the mine during the closing
period. If the copper prices are increased enough, the management will
be able to reopen the temporarily closed mine at a reopening cost (Co ) of
$0.2m. Otherwise, it has the option to abandon the mine at no cost (Va = 0).
As assumed by Brennan and Schwartz (1985), the copper price S evolves
according to the following geometric Brownian motion:
dS
= αdt + σ dz (4)
S
where α is the price trend, σ is the standard deviation, and dz is the incre-
ment to a standard Gauss-Wiener process. We restricted ourselves to the
simple model of Equation (4) in order to be able to compare our results
with those of Brennan and Schwartz (1985). However, the LSM method
can handle more complex stochastic processes such as the two-factor and
the three-factor models developed by Schwartz (1997). Under the risk-
neutral measure, the spot price evolves according to the following contin-
uous stochastic process
where r is the risk-free interest rate and δ is the convenience yield. Based
on the data presented in Table 1, the values of r, δ, and σ are 10%, 1%,
and 28.28% per year, respectively. The reported value of r represents the
nominal risk-free rate. Based on a cost inflation rate of 8% per year, the
real value of r is 2% per year. Samples of future prices after a short time
Valuing Real Capital Investments 149
mine, respectively. These critical prices are very close to those of $0.44/lb
and $0.76/lb for closing and reopening the mine obtained by Brennan and
Schwartz (1985). This similarity indicates that the LSM is an accurate
technique for determining the optimum mine status.
In this section we compare the results of our work in extending the LSM
method to value natural resource investments with the other attempts car-
ried out in the same topic. Based on our knowledge, there are three previ-
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ous attempts to apply Monte Carlo simulation for valuing natural resource
projects. The first attempt was carried out by Cortázar (2001) using a differ-
ent approach, based on the algorithm of Barraquand and Martineau (1995),
to value the same copper mine presented in Brennan and Schwartz (1985)
and to determine the optimal switching policy. The valuation results of
Cortazar are listed in Table 3. Comparing the valuation results in Table 3
and the threshold copper prices for changing the mine status, it is clear that
although the approach applied by Cortazar has generated accurate valua-
tion results, it failed to determine the accurate optimal switching policy.
As shown in Table 4, the difference between the values of the open and
the closed mine equals $0.2m (the reopening cost) when the initial copper
price is $0.7/lb or higher, which indicates that the threshold copper price to
reopen the closed mine is between $0.6/lb and $0.7/lb. On the other hand,
when the initial copper price is less than or equals $0.5/lb, the value of
the closed mine exceeds that of the open mine by $0.2m (the closing cost)
which indicates that the threshold price to close the mine is between $0.5/lb
and $0.6/lb. These threshold prices are different from both those estimated
by Brennan and Schwartz and our extended LSM method.
The second attempt to apply the LSM method in valuing natural re-
source investments was that of Tsekrekos et al. (2003). They applied the
LSM method to value the hypothetical copper mine treated in Brennan and
Schwartz (1985). As indicated in Table 3, the valuation results of Tsekrekos
et al. are very close to those of Brennan and Schwartz and ours, but the
threshold copper price to reopen the closed mine is very confusing. Look-
ing at Table 4, the difference between the value of the open and the closed
mine in Tsekrekos et al.’s results is $0.18m, $0.2m, and $0.19m when the
initial copper price was $0.8/lb, $0.9/lb, and $1.0/lb, respectively. Since
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our implementation of the LSM method has generated threshold prices for
switching the mine mode that are very close to those of the finite difference
technique. The difference in the valuation results can be owed to some tech-
nical and computational factors. The technical factor affecting the quality
of valuation results includes the rules and conditions set to control the
transition from one operating mode to the other. The computational factor
includes the parameters used in the simulation process such as the number of
sample paths generated and the length of each time step set to approximate
the continuous early exercise feature of American options. If the switching
policy is appropriately implemented, a sufficiently large number of simu-
lation paths are generated and the length of each time step is set as small as
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implicitly assumes that all the metal prices follow the same stochastic
process with the exact parameters and the exact correlation coefficients
with the stock market. Since this assumption does not hold, then ex-
pressing all metals in one metal-equivalent can lead to wrong valuation
results.
For valuing the multi-metal mine using the LSM, it is assumed that
the prices of gold, silver, and palladium follow the stochastic process in
Equation (4) while the prices of nickel, copper, cobalt, and platinum follow
the mean-reverting process, proposed by Schwartz (1997), such as:
where η is the reversion speed, µ is the logarithm of the equilibrium price S̄,
and the other symbols are as defined before. The parameters of the stochas-
tic processes for each metal are listed in Table 6 along with the correlation
coefficient with the market. The risk-adjusted prices are determined by
subtracting the risk premium of each metal from the drift of its stochastic
process. The risk premium of each metal is the product of its standard de-
viation, its correlation coefficient with the market and the market price of
risk.
The valuation process is carried out as described before. Table 7 lists
the simulation and regression parameters used in valuing the multi-metal
Valuing Real Capital Investments 155
mine. At each decision time, the manager can choose to change the operat-
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ing mode (open/closed) of the mine and pay the $0.4m switching cost, or
abandon the mine early at no cost, since the abandonment cost is assumed
to be zero. During the shutting period a maintenance cost of $0.6m will be
incurred annually. The valuation process is carried out recursively, deter-
mining the optimum operating mode at each decision date and revising the
cash flows in accordance. The mine value is then determined by discount-
ing the cash flows at the risk-free rate and averaging over the number of
paths. The mine value with the operating flexibilities to shut down the mine
temporarily and abandon it early has been found to be $14.82m. When con-
sidering the option to abandon only, the mine value is estimated at $13.81m.
The estimated mine value without any kind of operating flexibilities (i.e.,
with the classical net present value method) is $9.27m. This indicates that
the value of the option to abandon the mine early equals $4.54m (49%
of the net present value estimated without the operating flexibilities), while
the value of the option to shutdown the mine temporarily equals $1.01m
(11% of the net present value estimate).
Now it is important to examine the reasonability of the LSM method
in valuing the operating flexibility of multi-metal mines. Two tests are
performed to ensure that the value of the operating flexibility obtained by
the LSM is reasonable in the real company’s context. First, a company is
willing to quantify the value of the operating flexibility when it is uncertain
about the outcomes of future metal prices. If the company knows certainly
the future prices, it would use the traditional NPV method to evaluate its
project since there would be no need to use a more advanced technique such
as the real options. This implies that, in the context of the real industry, there
is a direct relationship between the level of uncertainty and the value of
the operating flexibility. Now let us see how does this work with the LSM.
Figure 1 shows the value of the operating flexibility, which is the difference
between the real options value and the NPV, at different percentages of the
actual values of the standard deviations listed in Table 6. It is obvious that
as the level of uncertainty increases, the value of the operating flexibility
increases. When the level of uncertainty is very low, which implies that the
156 S.A.A. Sabour and R. Poulin
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future prices are certainly known, the operating flexibility has no value.
This is exactly consistent with the real industry thought and experience
related to the issue of the operating flexibility and its relation to the level
of uncertainty. It is worth noting that the value of the operating flexibility
shows a fast decay as the level of uncertainty decreases due to the existence
of the shutting cost, the reopening cost and the maintenance cost to be
incurred during the shutt-down period.
The second test is related to the level of initial metal prices (current prices
at the evaluation stage) and its effect on the management attitude toward
quantifying the value of the operating flexibility. In practice, if the initial
metal prices are sufficiently high to make a real profit margin, the company
usually does not give much attention to evaluate the possibility of shutting
down or abandon its project. In contrary, when the profit margin is small,
the company will have to evaluate its production policy and its available
alternatives to avoid possible future losses if the prices are decreased. This
indicates that the real industry valuates the operating flexibility as small in
case of higher prices and as high in case of lower prices. To examine how
1 The calculations used in plotting Figures 1 and 2 are carried out using 4 time steps per year,
20,000 simulations, the first five terms of the power series as basis functions, and the moment
matching method as a variance reduction technique.
Valuing Real Capital Investments 157
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the valuation results of the LSM are consistent with this practical judgment,
the value of the operating flexibility is estimated at different levels of the
initial metal prices (% of S0 ). As shown in Figure 2, as the initial prices
level increases the value of the operating flexibility decreases. This result
agrees with both the practical experience and the scientific interpretation.
If the initial prices are high, the probability that they will fall sufficiently to
produce a negative operating profit decreases, the probability that the mine
will be closed or abandoned decreases and consequently the value of the
operating flexibility decreases. In case of low initial prices, the probability
that the mine will be closed or abandoned increases, and accordingly the
value of the operating flexibility increases.
CONCLUSIONS
mine temporarily during low price periods and abandon it are 11 and 49%,
respectively, of the classical NPV estimate. Consistent with the real industry
experiences, the value of the operating flexibility has been found to be
growing directly with the level of uncertainty and inversely with the level
of initial metal prices.
REFERENCES
Tsitsiklis, J.N. and B. Van Roy. (2001) “Regression methods for pricing complex
American-style options.” IEEE Transactions on Neural Networks, Vol. 12, No. 4,
pp. 694–703.
BIOGRAPHICAL SKETCHES
DR. SABRY A. ABDEL SABOUR is the lecturer of mineral economics at Mining and Met-
allurgical Engineering Department, Faculty of Engineering, Assiut University, Egypt
(sabrysabour@yahoo.com; sabry.abdel-hafez.1@ulaval.ca). In September 2000 he obtained
his Ph.D. in mineral economics. His research focuses on applying the real options approach
for evaluating natural resource investments. He is currently a visiting scholar at Université
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DR. RICHARD POULIN is the professor of mineral economics at Université Laval, Québec City,
Canada (Richard.Poulin@vrex.ulaval.ca; richard.poulin@fsg.ulaval.ca). He holds a Ph.D.
from McGill University. He has been a professor at the University of British Columbia
and previously worked in engineering for 12 years. His main research topics are mineral
resource valuation by real options and risk associated with environmental bonding.