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On A Finite Horizon Starting And Stopping Problem With Risk Of Abandonment

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  • BOUALEM DJEHICHE

    (Department of Mathematics, The Royal Institute of Technology, S-100 44 Stockholm, Sweden)

  • SAID HAMADÈNE

    (Université du Maine, Département de Mathématiques, Equipe Statistique et Processus, Avenue Olivier Messiaen, 72085 Le Mans, cedex 9, France)

Abstract

We address the issue of finding a strategy to sustain structural profitability of an investment project, whose production activity depends on the market price of a number of underlying commodities. Depending on the fluctuating prices of these commodities, the activity will either continue until the project's profitability reaches a critical low level at which it is stopped and starts again when it becomes profitable. But, if the structural nonprofitability remains for a while, the investment project will face the risk to be abandoned or be definitely closed. We suggest a general probabilistic set up to model profitability as a function of the market price of a set of commodities, and find the related optimal strategy to sustain it, under the constraint that the project faces the abandonment risk when being nonprofitable under a fixed finite time interval. When the market price dynamics is described by a diffusion process, we show that the optimal strategy is related to viscosity solutions of a system of two variational inequalities with inter-connected obstacles.

Suggested Citation

  • Boualem Djehiche & Said Hamadène, 2009. "On A Finite Horizon Starting And Stopping Problem With Risk Of Abandonment," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 12(04), pages 523-543.
    • Handle: RePEc:wsi:ijtafx:v:12:y:2009:i:04:n:s0219024909005312
    DOI: 10.1142/S0219024909005312
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    References listed on IDEAS

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    1. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474.
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    Cited by:

    1. Johnson, Timothy C. & Zervos, Mihail, 2010. "The explicit solution to a sequential switching problem with non-smooth data," LSE Research Online Documents on Economics 29003, London School of Economics and Political Science, LSE Library.
    2. El Asri, Brahim, 2013. "Stochastic optimal multi-modes switching with a viscosity solution approach," Stochastic Processes and their Applications, Elsevier, vol. 123(2), pages 579-602.
    3. Hamadène, Said & Zhang, Jianfeng, 2010. "Switching problem and related system of reflected backward SDEs," Stochastic Processes and their Applications, Elsevier, vol. 120(4), pages 403-426, April.

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