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Title:Simulation-based valuation of project finance: does model complexity really matter? PDF Logo
Authors:Weber, Florian
Schmid, Thomas
Pietz, Matthäus
Kaserer, Christoph
Issue Date:2010
Series/Report no.:CEFS working paper series 2010-03
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.
Subjects:Project Finance
Investment Valuation
Stochastic Modeling
Monte Carlo Simulation
Forecasting
Model Complexity
JEL:C63
Q40
Document Type:Working Paper
Appears in Collections:CEFS Working Paper Series, Center for Entrepreneurial and Financial Studies, Technische Universität München

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