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Simulation-based valuation of project finance: does model complexity really matter?

Author

Listed:
  • Weber, Florian
  • Schmid, Thomas
  • Pietz, Matthäus
  • Kaserer, Christoph

Abstract

This paper analyzes the impact of model complexity on the net present value distribution and the expected default probability of equity investments in project finance. Model complexity is analyzed along two dimensions: simulation complexity and forecast complexity. We aim to identify model elements which are crucial for the valuation of project finance in practice. First, we present a simulation-based project finance valuation model. Second, we vary several model aspects in order to analyze their impact on the valuation result. For forecast complexity, we apply different volatility and correlation forecasting techniques, e.g. correlation forecasts based on historical values and on a dynamic conditional correlation (DCC) model. Regarding simulation complexity, the number of Monte Carlo iterations, the equity valuation method, and the time resolution are varied. We find that the applied volatility forecasting models have a strong influence on the expected net present value distribution and on the probability of default. In contrast, correlation forecasting models play a minor role. Time resolution and equity valuation are both crucial when specifying a valuation model for project finance. For the number of Monte Carlo iterations, we demonstrate that 100,000 iterations are sufficient to obtain reliable results.

Suggested Citation

  • Weber, Florian & Schmid, Thomas & Pietz, Matthäus & Kaserer, Christoph, 2010. "Simulation-based valuation of project finance: does model complexity really matter?," CEFS Working Paper Series 2010-03, Technische Universität München (TUM), Center for Entrepreneurial and Financial Studies (CEFS).
  • Handle: RePEc:zbw:cefswp:201003
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    References listed on IDEAS

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    1. Stefano Gatti & Alvaro Rigamonti & Francesco Saita & Mauro Senati, 2007. "Measuring Value-at-Risk in Project Finance Transactions," European Financial Management, European Financial Management Association, vol. 13(1), pages 135-158.
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    5. Chemmanur, Thomas J. & John, Kose, 1996. "Optimal Incorporation, Structure of Debt Contracts, and Limited-Recourse Project Financing," Journal of Financial Intermediation, Elsevier, vol. 5(4), pages 372-408, October.
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    More about this item

    Keywords

    Project Finance; Investment Valuation; Stochastic Modeling; Monte Carlo Simulation; Forecasting; Model Complexity;

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • Q40 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - General

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