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On an optimal extraction problem with regime switching

Abstract

In this paper we study a finite-fuel two-dimensional degenerate singular stochastic control problem under regime switching motivated by the optimal irreversible extraction problem of an exhaustible commodity. A company extracts a natural resource from a reserve with finite capacity and sells it in the market at a spot price that evolves according to a Brownian motion with volatility modulated by a two-state Markov chain. In this setting, the company aims at finding the extraction rule that maximizes its expected discounted cash flow, net of the costs of extraction and maintenance of the reserve. We provide expressions for both the value function and the optimal control. On the one hand, if the running cost for the maintenance of the reserve is a convex function of the reserve level, the optimal extraction rule prescribes a Skorokhod reflection of the (optimally) controlled state process at a certain state and price-dependent threshold. On the other hand, in the presence of a concave running cost function, it is optimal to instantaneously deplete the reserve at the time at which the commodity's price exceeds an endogenously determined critical level. In both cases, the threshold triggering the optimal control is given in terms of the optimal stopping boundary of an auxiliary family of perpetual optimal selling problems with regime switching.

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Corresponding author

* Postal address: Center for Mathematical Economics, Bielefeld University, Universitätsstrasse 25, D-33615 Bielefeld, Germany. Email address: giorgio.ferrari@uni-bielefeld.de
** Postal address: Institution of Financial Studies, Shandong University, Jinan, Shandong, 250100, P. R. China. Email address: yangsz@sdu.edu.cn

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Advances in Applied Probability
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