Pontificia Universidad Católica de Chile Pontificia Universidad Católica de Chile
Cortázar G., Naranjo L., Sainz F. (2020)

Optimal decision policy for real options under general Markovian dynamics

Revista : European Journal of Operational Research
Volumen : 288
Número : 2
Páginas : 634-647
Tipo de publicación : ISI Ir a publicación


The Least-Squares Monte Carlo Method (LSM) has become the standard tool to solve real options modeledas 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 ?rst validated under a one-dimensional geometric Brownian motion and then extended to general Markovian processes. We consider two general speci?cations: a two-factor model with stochasticvariance 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 morepro?table strategy than the one obtained with LSM.