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Unformatted text preview: ertain level of
variance, which is equivalent to minimising the variance under a certain level of
expected return. To determine the variance, Monte Carlo simulation is used. First,
information about all the variables that affect the calculation of a cash flow of one of
the projects is collected and their probability distributions are estimated. Then for
each project, using Monte Carlo simulation, a number of cumulative discounted cash
flows and their matching discounted investments can be generated simultaneously.
From these points, the EMV of each project, the variance of the EMV of each project
and the correlation between the EMVs of the different projects can be calculated. By
simulating the cash flows of all projects simultaneously, some of the uncertain
variables, which fix the systematic risk and thus provide for the correlation between
the different projects, are equal for all projects and therefore the coefficient of
correlation between projects can be determined. (The value of this coefficient can
range from +1 in the case of perfect correlation, where the two assets move together,
to –1 in the case of perfect negative correlation, where the two assets always move in
opposite directions. The coefficient is 0 when there is no association between the
assets and they are said to be independent.) Then these values, together with any
other constraints, are used to generate the efficient frontier. To find the efficient
portfolios, Markowitz defined the mean variance model that reduces to a quadraticprogramming problem that is easily solved by the many mathematical software
packages available. After the efficient set has been determined, a portfolio can be
chosen from this group. There are several ways of doing this. For the method
advocated by Markowitz (and stochastic dominance) the utility function, or
preference curve, of the company would need to be determined, as discussed above in
section 5.3, this is particularly difficult. Therefore some finance theorists advocate
the use of one of the safety-first criteria (for a full discussion see Ross, 1997). 108 Investment opportunities of the oil industry have a great resemblance to financial
assets. As with the financial assets, there is much risk and uncertainty about the profit
of the projects. Assets are highly correlated with each other. They all have some
variables, such as oil price, that affect the profitability of the project in common. In
the stock market paper assets (stocks and shares) are traded and in the oil business
companies hold and trade portfolios of real assets by, for instance buying and selling
shares in joint ventures.
The following simple example from Ball and Savage (1999) shows how the
application of the principles of portfolio theory to the oil industry can result in
decisions that are counter-intuitive.
An oil company has $10 million to invest in exploration and production projects.
Only two projects are available and each requires the full $10 million for 100%
interest. One project is relatively “safe”; the other relatively “risky”. The chances of
success are independent. The facts about the projects are presented in tabl...
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This document was uploaded on 03/30/2014.
- Summer '14
- The Land