Journal of Computational Finance

Risk.net

An application of natural resource evaluation using a simulation-dynamic programming approach

Augusto Castillo-Ramiré

ABSTRACT

In this paper, the author adjusts a hybrid of a simulation and dynamic programming algorithm recently developed to price American options, in order to value a copper mine that offers the options of being closed, reopened, or abandoned, with some finite frequency. The proposed methodology is tested using the same numerical example given by Brennan and Schwartz (1985), and very similar results are obtained. The discrepancies are mainly due to differences in the assumptions made in terms of the time horizon available to exercise the options and exploit the mine and the frequency with which those decisions can be made. An extension of the basic model is also developed where the prices, the convenience yields, and the production cost are modeled as random variables. The methodology presented here allows for the valuation of high-dimensional option-type securities, i.e. the ones whose values are a function of several variables.

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