Financial Hedging of Operational Flexibility

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.