Title: Operating Leverage and the Interaction between Abandonment Options and Exotic Hedging
Reference Number: 1109
Publication Date: July 2004
JEL Classifcation: D21, D81, G31
Author(s):

Wong Kit Pong
The University of Hong Kong

Abstract:

This paper examines the interaction between operational and financial hedging in the context of the competitive firm under output price uncertainty. The firm is endowed with an abandonment option in that its production decision is made after the true realization of the random output price has been observed. If the realized output price is less than its marginal cost, the firm optimally exercises its abandonment option and ceases from production. Otherwise, the firm lets its abandonment option extinguish and produces at its capacity. The existence of the abandonment option is shown to induce the firm to opt for a concave payoff risk-sharing rule that can be perfectly replicated by writing call options with a single strike price set equal to the marginal cost. We derive necessary and sufficient conditions that ensure a positive (negative) effect of operational hedging via the abandonment option on the firm's optimal operating leverage. In contrast, we show that the effect of financial hedging via customized exotic derivatives on the firm's optimal operating leverage is unambiguously positive. These results suggest that the interaction between abandonment options and exotic hedging is multi-dimensional and deserves further scrutiny.

More:

Published in Journal of Derivatives Accounting 2:1 (2005), pp. 1-10.

Key words: Operating leverage, Abandonment options, Exotic hedging

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Last modified: 01/24/2007