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A graphical method for valuing switching options

Author

Listed:
  • B R Cobb

    (Virginia Military Institute)

  • J M Charnes

    (Bank of America Corporate Center)

Abstract

This paper introduces a graphical method for valuing options on real asset investments that allow the investor to switch between different operating modes at a single point-in-time. The technique uses mixtures of truncated exponential functions to approximate both the probability density function for project value and the expressions for option value of each alternative. The distribution for project value is transformed into an expected cash flow function for the option under each mode of operation. After determining an optimal exercise strategy, these functions are used to determine the option value. The graphical method allows the option exercise strategy to be communicated effectively through a graphical representation of the expected cash flow functions. A comparison of this approach to the existing binomial lattice method is presented. The efficiency of the graphical method is comparable to the binomial lattice and in some cases accurate solutions can be obtained with less CPU time.

Suggested Citation

  • B R Cobb & J M Charnes, 2010. "A graphical method for valuing switching options," Journal of the Operational Research Society, Palgrave Macmillan;The OR Society, vol. 61(11), pages 1596-1606, November.
    • Handle: RePEc:pal:jorsoc:v:61:y:2010:i:11:d:10.1057_jors.2009.128
    DOI: 10.1057/jors.2009.128
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    References listed on IDEAS

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    1. Cobb, Barry R. & Shenoy, Prakash P., 2008. "Decision making with hybrid influence diagrams using mixtures of truncated exponentials," European Journal of Operational Research, Elsevier, vol. 186(1), pages 261-275, April.
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    5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    6. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
    7. James E. Smith, 2005. "Alternative Approaches for Solving Real-Options Problems," Decision Analysis, INFORMS, vol. 2(2), pages 89-102, June.
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