Title: The Effects of Abandonment Options on Operating Leverage and Forward Hedging
Reference Number: 1088
Publication Date: October 2003
JEL Classifcation: D21, D81, G31
Author(s):

Kit Pong Wong
The University of Hong Kong

Abstract:

This paper examines the behavior of the competitive firm under output price uncertainty when the firm is endowed with an abandonment option and has access to a forward market for its output. When the realized output price is less than its marginal cost, the firm optimally exercises its abandonment option and ceases from production. The firm lets its abandonment option extinguish, thereby producing up to its capacity, only when the realized output price exceeds its marginal cost. The ex post exercising of the abandonment option as such convexifies the firm's ex ante profit with respect to the random output price. We show that neither the separation theorem nor the full-hedging theorem holds in the presence of the abandonment option. The firm under-hedges its output price risk exposure in the forward market wherein the forward price contains a non-positive risk premium. When the set of hedging instruments is expanded to include options, we show that both the separation and full-hedging theorems are restored. We further show that the firm prefers options to forwards for hedging purposes when both types of contracts are fairly priced.

More:

Published in International Review of Economics and Finance 15:1 (2006), pp. 72-86.

Key words: Abandonment options, Operating leverage, Forwards, Options

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Last modified: 01/24/2007