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Financial Hedging Of Operational Flexibility

Author

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  • MICHAEL LUDKOVSKI

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

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.

Suggested Citation

  • Michael Ludkovski, 2008. "Financial Hedging Of Operational Flexibility," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 11(08), pages 799-839.
    • Handle: RePEc:wsi:ijtafx:v:11:y:2008:i:08:n:s0219024908005044
    DOI: 10.1142/S0219024908005044
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    Cited by:

    1. Dahlgren, Eric & Leung, Tim, 2015. "An optimal multiple stopping approach to infrastructure investment decisions," Journal of Economic Dynamics and Control, Elsevier, vol. 53(C), pages 251-267.
    2. Giorgia Callegaro & Luciano Campi & Valeria Giusto & Tiziano Vargiolu, 2017. "Utility indifference pricing and hedging for structured contracts in energy markets," Mathematical Methods of Operations Research, Springer;Gesellschaft für Operations Research (GOR);Nederlands Genootschap voor Besliskunde (NGB), vol. 85(2), pages 265-303, April.
    3. Michael Ludkovski, 2010. "Stochastic Switching Games and Duopolistic Competition in Emissions Markets," Papers 1001.3455, arXiv.org, revised Aug 2010.

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