Financial Hedging of Operational Flexibility

  • Date: 01/24/2008

Mike Ludkovski (University of Michigan)


University of British Columbia


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 numerical examples and comparative statics and
show how the model can be extended to cover other applications of
interest, such as gas storage valuation.

Other Information: 

MITACS Math Finance Seminar 2008