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Mean Reversion with Drift and Real Options in Steel Industry

Author

Listed:
  • Luiz de Magalhães Ozorio

    (Ibmec Business School)

  • Carlos de Lamare Bastian-Pinto

    (Unigranrio University)

  • Tara Nanda Baidya

    (Pontifical Catholic University of Rio de Janeiro (PUC-Rio))

  • Luiz Eduardo Teixeira Brandão

Abstract

Steel is a commodity with significant price volatility and the choice of stochastic process that better describes its price performance is a fundamental issue in real options valuation in steel industry projects. As verified with other commodities, it is assumed that steel prices can be led partially by a mean reversion component, but the analysis of some economic issues related to production indicates that steel prices may also have a rising drift component. This, in practical terms, would increase the long term mean with time. This work presents a model that we call Mean Reversion with Drift (MRM-D), in which a deterministic tendency is attached to the long term equilibrium level in order to capture the increase of steel production marginal cost. It then evaluates the implications of using this model in valuation of steel sector projects.

Suggested Citation

  • Luiz de Magalhães Ozorio & Carlos de Lamare Bastian-Pinto & Tara Nanda Baidya & Luiz Eduardo Teixeira Brandão, 2012. "Mean Reversion with Drift and Real Options in Steel Industry," Brazilian Review of Finance, Brazilian Society of Finance, vol. 10(2), pages 215-241.
    • Handle: RePEc:brf:journl:v:10:y:2012:i:2:p:215-241
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    More about this item

    Keywords

    stochastic processes; real options; mean reversion models; steel industry;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • L61 - Industrial Organization - - Industry Studies: Manufacturing - - - Metals and Metal Products; Cement; Glass; Ceramics
    • M21 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Economics - - - Business Economics

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