Chap 6. Compound and Switching Options. Compound and Switching Options. Compound options are options whose value is contingent on other options.
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Compound and Switching Options
First, we value the equity as an American call on the value of the firm with its exercise price equal to the face value of debt.
These switching costs are designed Cxy and Cyx respectively.
The flexible technology Z requires a higher investment of $110.
We ask the same question twice :
Assuming we have been in mode X at the previous state, would we stay in X or would we switch to Y and pay the switching cost?
Assuming we have been in mode Y at the previous state, would we stay in Y or would we switch to X and pay the switching cost?