Optimal decision policy for real options under general Markovian dynamics

Gonzalo Cortazar, Lorenzo Naranjo and Felipe Sainz

European Journal of Operational Research, 2021, vol. 288, issue 2, 634-647

Abstract: The Least-Squares Monte Carlo Method (LSM) has become the standard tool to solve real options modeled as an optimal switching problem. The method has been shown to deliver accurate valuation results under complex and high dimensional stochastic processes; however, the accuracy of the underlying decision policy is not guaranteed. For instance, an inappropriate choice of regression functions can lead to noisy estimates of the optimal switching boundaries or even continuation/switching regions that are not clearly separated. As an alternative to estimate these boundaries, we formulate a simulation-based method that starts from an initial guess of them and then iterates until reaching optimality. The algorithm is applied to a classical mine under a wide variety of underlying dynamics for the commodity price process. The method is first validated under a one-dimensional geometric Brownian motion and then extended to general Markovian processes. We consider two general specifications: a two-factor model with stochastic variance and a rich jump structure, and a four-factor model with stochastic cost-of-carry and stochastic volatility. The method is shown to be robust, stable, and easy-to-implement, converging to a more profitable strategy than the one obtained with LSM.

Keywords: OR in natural resources; Real options; Optimal switching problem; Numerical methods in finance (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ejores:v:288:y:2021:i:2:p:634-647

DOI: 10.1016/j.ejor.2020.06.010

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