FINANCIAL HEDGING OF OPERATIONAL FLEXIBILITY

Michael Ludkovski ()
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Michael Ludkovski: Department of Mathematics, University of Michigan, 530 Church St., Ann Arbor MI 48109, USA

International Journal of Theoretical and Applied Finance (IJTAF), 2008, vol. 11, issue 08, 799-839

Abstract: We extend the framework of real options to value the compound timing option owned by a manager of an industrial asset. The operator has control over the production modes, but faces operational constraints which introduce path-dependency. Moreover, the operator is only able to imperfectly hedge her income on the futures market. Using an exponential indifference valuation approach we construct a combined stochastic control formulation that merges the problems of optimal switching and indifference pricing in incomplete markets. We then present an iterative scheme for valuing operational flexibility which in particular shows additivity of indifference value over time. After discussing details of numerical implementation, we illustrate our results with several computational examples and comparative statics.

Keywords: Operational flexibility; indifference pricing; compound options; stochastic income (search for similar items in EconPapers)
Date: 2008
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Citations: View citations in EconPapers (5)

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DOI: 10.1142/S0219024908005044

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