Valuing Switching Options with the Moving-Boundary Method

Shaunak S. Dabadghao (Corresponding author), Arun Chockalingam, T. Soltani, Jan C. Fransoo (Corresponding author)

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Abstract

Switching options can be deployed in various complex switching problems such as tolling agreements and the offshoring-backshoring problem. Closed form solutions to valuing switching options are not only hard, but also computationally intensive when solving numerically. We develop a new computational method to value switching options based on the moving boundary method. We show how the free boundary problem arising from switching options can be converted into a sequence of fixed boundary problems. We formulate the problem, and solve the optimal switching problem in two regimes over a finite time horizon. We establish the theoretical guarantees for this method (maximum principles, uniqueness and convergence). We demonstrate this with a numerical example and show the sensitivity of the solution with regard to the problem parameters.
Original languageEnglish
Article number104124
JournalJournal of Economic Dynamics and Control
Volume121
Early online date18 Apr 2021
DOIs
Publication statusE-pub ahead of print - 18 Apr 2021

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