Hedging entry and exit decisions activating and deactivating barrier options.pdfVIP

JOURNAL OF APPLIED MATHEMATICS AND DECISION SCIENCES, 6(1), 51–70 c Copyright 2002, Lawrence Erlbaum Associates, Inc. Hedging Entry and Exit Decisions: Activating and Deactivating Barrier Options LAURENT GAUTHIER† lg@ 15 W 73rd St, Apt 2, New York, NY 10023, USA. Abstract. Investment projects and businesses can be entered or exited at a cost, and the theory of real option teaches us how to find optimal activity levels that should trigger entry or exit. However, in practice, different managers or owners operate under different constraints and might apply different thresholds to the same business. We are interested in the hedging of the risk related to the cost of sub-optimal entry or exit. We introduce a new class of derivative products that can hedge this risk. The pricing of these derivatives involves the joint law of a Brownian excursion and its supremum, which is calculated thanks to Bessel processes-related distribution laws. Keywords: Real options, investment decision, Brownian meander, exotic options 1. Introduction Real option theory establishes an analogy between monopolistic investment projects and financial options. An investment project, indeed, contains an option to wait for a better time to invest, depending on the evolution of the random variables that condition the project’s profitability (such as market share, commodity prices or labor costs). The classical Net Present Value rule, which prescribes investment as soon as a positive value is generated today, does not take into account the value contained in the option to wait. The option to exit an investment that has proven unattractive also possesses a value. Entry or exit are in most cases costly; there is an often important fixed cost in stopping a manufacturing plant, or restarting it. Und