Financial Engineering Seminar
December 1, 2006 (Fri)
Time: 3:00 pm
Place: 303 Weil Hall (conference room)
We study the problem of optimal financial hedging of operational flexibility. The motivation comes from managing energy assets, where the operator has control of the physical asset as well as opportunity for imperfect hedging on futures markets. In terms of control terminology, we have a combined stochastic control problem that uses both continuous controls (for financial hedging), as well as impulse control (for selecting the operational regime). Our solution is based on separating the two types of controls and reducing it to a sequence of stochastic control with discretionary stopping sub-problems. This allows for an efficient numerical implementation if the sub-problem admits a solution. An important case where this occurs is with exponential utility that admits a closed-form formula in terms of conditional expectations, cf. Musiela and Zariphopoulou (2003). We implement this situation with a regression Monte-Carlo scheme and illustrate the solution structure. The second part of the talk then shows how the model can be extended to cover other applications of interest, such as gas storage valuation. Finally, we will discuss use of general dynamic risk measures in this problem.