Optimal Investment Policy for Real Option Problems with Regime Switching

TL;DRAbstract

Abstract Real option analysis (ROA) is a way of valuing real assets by invoking option pricing theory. In contrast to the traditional net present value approach, ROA makes it possible to explicitly incorporating management flexibility. Because of such advantages, ROA has become an important tool for project valuation and is widely used in practice. In this paper, we develop a real option model with regime switching. In addition to stochastic fluctuation over time, the value process also depends on a regime process described by a two-state Markov chain. By extending standard approach based on Bellman equation and smooth pasting condition, we investigate the optimal investment policy and value functions. Unlike the existing real option models with single stochastic factor, two types of solution are possible according to model parameters. We also develop numerical procedures to compute the optimal policy and provide some numerical examples.

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