PRACTICAL RISK MANAGEMENT
Workshop assignment
Bidding for Antamina
In this assignment you will explore the use of real options to evaluate the investment opportunity of developing a copper mine in Peru. If you haven’t done so please read the related HBS school case which is included the course folder. A spreadsheet called Antamina2.xls has been prepared to analyse the case.
Task 1:
Spend some time trying to understand the developed model. Some of the underlying assumptions are briefly explained below.
· The firm’s only option included in the model is the option not to develop the mine in year 2 depending on metal prices. (Question: What other options does the bidder for the project have available which are not modelled here?)
· The distribution of possible ore quantities are known, discrete and independent of the metal prices. More specifically three different scenarios are used (high, expected, low) to model this uncertainty.
· Only two years of metal prices are modelled. The assumption is that the company will hedge sales with forward contracts. The forward prices are calculated on the basis of prices at year 2 and the estimated convenience yields for copper and zinc[1]. The prices and convenience yields are assumed to be correlated. Also convenience yields are mean reverting.
· Only metal quantity and metal price risk are modelled. (Question: What other risks you might want to consider?)
Task 2:
Use Monte Carlo simulation to answer the questions
a) What would the value of the project if you were forced to develop the mine?
b) How does the fact that you have a choice of developing the mine at the end of the two years affect the value of the project?
c) How is the value of the option not to develop the project affected by the volatility in metal prices?
Task 3:
How does the structure of the bidding rules affect the tradeoff between initial cash payment and investment commitment? (Qualitative analysis – no need to run simulations).
Task 4:
Examine the impact of different bidding strategies on the project value to the winning bidder after taking into account the initial cash payment and the possible penalties from under-investment. More specifically, how does the project value vary with the size of the investment commitment? How does the probability of developing the mine vary with the size of the investment commitment? Comment of the incentive structure provided by the bidding rules.
Task 5:
Based on your analysis provide advise to the bidders as to how to structure their bids. Try to predict the outcome of the bidding process.
[1] See Gibson and Schwartz “Stochastic convenience yields and the pricing of oil contingent claims”, Journal of Finance 45(3), 1990 for the technical details of estimating the stochastic processes and calculating forward prices.