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

Abstract

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. Barrier options are common in foreign exchange markets, and also arise in our analysis. The decision to delay commencement contingent on commodity prices rising requires an up-and-in type barrier option, 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 present closed form valuation formulae which we numerically implement using Excel spreadsheet software.