Operational Hedging in a Mean Reverting Environment - A Real Option Approach

This thesis investigates the value of operational hedging in the form of being able to temporarily close the production of silicone. With the use of real option theory, we developed a switching option model that estimates the value of being able to switch between open and closed production. The underlying risk factor in the model is the power prices, which has a great influence on the profitability in the production. Being a commodity, we argue that the power price follows a mean reverting process due to its circumstances. By making use of theories based on the Ornstein-Uhlenbeck process, the possible movements of the underlying asset have been predicted. The valuation of the real option is done through the use of binomial trees, risk-neutral probabilities and backward induction. By accounting for switching costs as well as fixed and other costs that depend on whether the plant is opened or closed, our model reveals the optimal strategy of production. The model reveals that introducing the flexibility that follows from the real option adds considerable value to the plant. Finally, we perform a sensitivity analysis which shows that small changes in some of the underlying factors can have a significant impact on the overall value, which is consistent with option theory