Valuing Flexibility as a Complex Option

Authors

  • ALEXANDER J. TRIANTIS,

  • JAMES E. HODDER

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    • University of Wisconsin-Madison and Stanford University, respectively. We would particularly like to thank Darrell Duffie, Robert Keeley, and an anonymous referee for their helpful comments on earlier versions of this paper. Comments from seminar participants at Harvard, M.I.T., Stanford, Toronto, Wisconsin, and York University are also appreciated. Much of the work on this paper was completed while the first author was a Visiting Scholar at M.I.T. and supported by an SSHRC Postdoctoral Fellowship. Support for the second author from the Stanford Institute for Manufacturing and Automation is also gratefully acknowledged.

ABSTRACT

This paper develops an approach for valuing flexible production systems using contingent claims pricing. Demand curves for our model's underlying assets (output products) may be downward sloping, in contrast with the standard option pricing assumption. Also, our marginal production(exercise) costs may be increasing. In addition, we allow for multiple products and a production capacity constraint. These elements of the model result in complex exercise decisions for the contingent claims which comprise the production system's value. We illustrate our approach by valuing a flexible system that produces two products which have profit margin functions with stochastic parameters.

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