» Multi-stage Investments with Real Options

Multi-stage Investments with Real Options

Many investment decisions involve multiple decision stages that have termination options. Information is revealed over time, and the ability to modify behaviour leads to a decision “tree”. Once uncertain outcomes and a changing environment over time are factored in, solving these types of problems becomes very complex. Stochastic Dynamic Programming provides a solution method that will solve these problems.

These models can be used in applications such as mining or oil exploration where testing can reveal better information at some cost.

Back to Our Solutions

PRODUCT STUDY

PROBLEM

A problem with real-world complexity is likely to involve some or all of the following aspects:

Multiple decision stages, potentially with termination options. For instance, an oil exploration project may involve seismic surveys, core samples, test wells and the like.
Several possible future outlooks possible at each decision stage.
Information such as prices or costs are revealed over time. This can affect our view about the profitability of each possible outcome.
Multiple projects possible, but with an overall budget or other constraints for all projects combined.
Once all of these factors are considered, we have a very complex problem.

SOLUTION

Stochastic Dynamic Programming is a very efficient method for solving large decision trees in a short period of time. At each combination of decision nexus and possible future state the SDP solver tells us the optimal decision to make.

RESULTS

Our custom-written solver creates the optimal solution for this type of solution in a very short period of time. As well as the optimal “roadmap” of decisions, outputs include such things as expected return, and expected cash flow.