A COMPOUND OPTION MODEL OF PRODUCTION AND INTERMEDIATE INVENTORIES

Abstract

This article extend the option approach to valuing real assets by modeling the firm as a two-stage process with bounded output rates in which the output of the first stage may be held as work-in-process. In this setting, the real asset becomes a compound option. which, if exercised, gives the option to finish the work-in-process and sell the output as its final payoff. The existence of intermediate inventories may arise as an optimal investment strategy for exploiting possible future price increases. The framework allows us to analyze the effect of uncertainty on output rates and the effect of interest rates changes on inventory levels.