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Real Options Analysis for Commodity Based Mining Enterprises with Compound and Barrier Features

Otto Konstandatos, Timothy Kyng
2012 Accounting and Finance Research  
Traditional project evaluations rely mainly on Net Present Value methodology, and largely ignore the flexibilities available to the sponsor to vary the project after initiation. Real Options Analysis remedies this by applying option pricing theory to more fully evaluate investment decisions. Through several hypothetical gold-mining examples, we illustrate the economic valuation of multi-stage investment decisions as simple or compound options, possibly with barrier option features. We present
more » ... tures. We present analytic valuation formulae for the types of compound options arising in this context, which differ from standard compound options. Barrier options are common in foreign exchange markets, and also arise in our analysis. We also present formulae for the valuation of the compound options appearing in our analysis with barrier features. It turns out that the decision to delay commencement contingent on commodity prices rising requires an up-and-in barrier option feature, whereas the risk of project nationalization may be modeled by adding an up-and-out barrier feature. Other barrier option features also arise in a Real Options context. We apply recently developed valuation methods for compound and barrier exotic options to several gold-mining examples, and we implement examples of the closed form valuation formulae using Excel spreadsheet software. Example 1: Assume a gold mining project with a three year life. Every three months we can extract 1,000 oz of gold and sell it into the market.
doi:10.5430/afr.v1n2p216 fatcat:dlort6pbhrhhxcwdlr2lcy4bpa