Real Options Problem with Non-Smooth Obstacle

Abstract

We consider a real options problem, which is posed as a stochastic optimal control problem. The investment strategy, which plays the role of control, involves a one-time option to expand (invest) and a one-time option to abandon (terminate) the project. The timing and amount of the investment and the termination time are parameters to be optimized in order to maximize the expected value of the profit. This stochastic optimization problem amounts to solving a deterministic variational inequality in dimension one, with the associated obstacle problem. Because we consider both cessation and expansion options and fixed and variable costs of expansion, the obstacle is non-smooth. Due to the lack of smoothness, we use the concept of a weak solution. However, such solutions may not lead to a straightforward investment strategy. Therefore, we further consider strong ($C^1$) solutions based on thresholds. We propose sufficient conditions for the existence of such solutions to the variational inequality with a non-smooth obstacle in dimension one. When applied to the real options problem, these sufficient conditions yield a simple optimal investment strategy with the stopping times defined in terms of the thresholds.