SENSITIVITY OF NET PRESENT VALUES AND REAL OPTION VALUES TO

Abstract

In export operation forecasting exercises the effect of stochastic input variables such as exchange rates and commodity prices are often ignored with the convention being to account for their uncertainty in discount rates. In the case where exchange rates are highly volatile, such as in the developing world, their effect on the uncertainty surrounding forecast Net Present Value (NPV) of the project can be pronounced. The objective of this research is to evaluate the effect of exchange rate volatility on NPV uncertainty or standard deviation. This is done in the context of a forecasting model used to determine the profitability of a proposed copper refinery. The analysis measures NPV mean and standard deviation for a range of exchange rate volatilities and evaluates their effect on these statistics. The research further considers what effect this has on the real option value of deferring the decision to invest. In considering practical mitigation of this currency risk a further analysis is done in which a simple hedging strategy is used. The results indicate that for an exchange rate volatility range of 0.5% to 10% (being a typical spread of stable economies around the world), there is no significant impact on NPV uncertainty. With real option value linked to the NPV standard deviation, this results in no significant effect on option value. Lastly, the results show that the simple hedging strategy does very little in reducing the effect of currency risk on NPV uncertainty.