Assessing Least Squares Monte Carlo for the Kulatilaka Trigeorgis General Real Options Pricing Model

Abstract

We assess the applicability of (Longstaff and Schwartz, 2001) Least Squares Monte Carlo method to the General Real Options Pricing Model of (Kulatilaka and Trigeorgis, 1994). We study LSMC under different stochastic processes: GBM, up to three dimensions, models 1, 2 and 3 in (Schwartz, 1997), benchmarking every application by lattice methods. We explore empirically a generalization of proposition 1 page 124 in (Longstaff and Schwartz, 2001) with respect to the number of discretization points, of basis functions and the number of simulated paths. We study the speed precision tradeoff of LSMC individual estimates. Finally, we show their statistical properties.

Keywords: Least Squares Monte Carlo, LSMC, Real Options, multi dimensional binomial lattices, moment matching, GBM, Geometric Ornstein Uhlenbeck, Two Factor Model, Three Factor Model, stochastic interest rates

JEL Classification: G13, G31