IDEAS home Printed from https://ideas.repec.org/a/eee/dyncon/v51y2015icp278-298.html
   My bibliography  Save this article

Uncertain dynamics, correlation effects, and robust investment decisions

Author

Listed:
  • Flor, Christian Riis
  • Hesel, Søren

Abstract

We analyze a firm׳s investment problem when the dynamics of project value and investment cost are uncertain. We provide an explicit solution using a robust method for an ambiguity averse firm taking this into account. Ambiguity aversion regarding a common risk factor impacts differently than ambiguity aversion regarding investment cost residual risk. Correlation between project value and investment cost matters; ambiguity aversion regarding common risk can decrease the investment probability only if correlation is positive. Ambiguity aversion regarding residual risk always increases the investment probability. When only project value is risky, volatility can monotonically decrease the investment threshold; this does not hold with the multiple prior method.

Suggested Citation

  • Flor, Christian Riis & Hesel, Søren, 2015. "Uncertain dynamics, correlation effects, and robust investment decisions," Journal of Economic Dynamics and Control, Elsevier, vol. 51(C), pages 278-298.
    • Handle: RePEc:eee:dyncon:v:51:y:2015:i:c:p:278-298
    DOI: 10.1016/j.jedc.2014.10.011
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0165188914002887
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.jedc.2014.10.011?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Lars Peter Hansen & Thomas J Sargent, 2014. "Robust Control and Model Uncertainty," World Scientific Book Chapters, in: UNCERTAINTY WITHIN ECONOMIC MODELS, chapter 5, pages 145-154, World Scientific Publishing Co. Pte. Ltd..
    2. Nishimura, Kiyohiko G. & Ozaki, Hiroyuki, 2007. "Irreversible investment and Knightian uncertainty," Journal of Economic Theory, Elsevier, vol. 136(1), pages 668-694, September.
    3. Boyle, Glenn W. & Guthrie, Graeme A., 2006. "Hedging the value of waiting," Journal of Banking & Finance, Elsevier, vol. 30(4), pages 1245-1267, April.
    4. Zengjing Chen & Larry Epstein, 2002. "Ambiguity, Risk, and Asset Returns in Continuous Time," Econometrica, Econometric Society, vol. 70(4), pages 1403-1443, July.
    5. Lars Peter Hansen & Thomas J Sargent, 2014. "Robust Control and Model Misspecification," World Scientific Book Chapters, in: UNCERTAINTY WITHIN ECONOMIC MODELS, chapter 6, pages 155-216, World Scientific Publishing Co. Pte. Ltd..
    6. Judson A. Caskey, 2009. "Information in Equity Markets with Ambiguity-Averse Investors," Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3595-3627, September.
    7. Brennan, Michael J & Schwartz, Edwardo S, 1978. "Corporate Income Taxes, Valuation, and the Problem of Optimal Capital Structure," The Journal of Business, University of Chicago Press, vol. 51(1), pages 103-114, January.
    8. Hansen, Lars Peter & Sargent, Thomas J., 2011. "Robustness and ambiguity in continuous time," Journal of Economic Theory, Elsevier, vol. 146(3), pages 1195-1223, May.
    9. Hans, Erwin & Wullink, Gerhard & van Houdenhoven, Mark & Kazemier, Geert, 2008. "Robust surgery loading," European Journal of Operational Research, Elsevier, vol. 185(3), pages 1038-1050, March.
    10. Morellec, Erwan & Zhdanov, Alexei, 2008. "Financing and takeovers," Journal of Financial Economics, Elsevier, vol. 87(3), pages 556-581, March.
    11. Boyle, Glenn W. & Guthrie, Graeme A., 2006. "Hedging the value of waiting," Journal of Banking & Finance, Elsevier, vol. 30(4), pages 1245-1267, April.
    12. Patrick Gagliardini & Paolo Porchia & Fabio Trojani, 2009. "Ambiguity Aversion and the Term Structure of Interest Rates," The Review of Financial Studies, Society for Financial Studies, vol. 22(10), pages 4157-4188, October.
    13. Raman Uppal & Tan Wang, 2003. "Model Misspecification and Underdiversification," Journal of Finance, American Finance Association, vol. 58(6), pages 2465-2486, December.
    14. Miao, Jianjun & Wang, Neng, 2011. "Risk, uncertainty, and option exercise," Journal of Economic Dynamics and Control, Elsevier, vol. 35(4), pages 442-461, April.
    15. Maenhout, Pascal J., 2006. "Robust portfolio rules and detection-error probabilities for a mean-reverting risk premium," Journal of Economic Theory, Elsevier, vol. 128(1), pages 136-163, May.
    16. M. Trojanowska & P. M. Kort, 2010. "The Worst Case for Real Options," Journal of Optimization Theory and Applications, Springer, vol. 146(3), pages 709-734, September.
    17. Dirk Hackbarth & Christopher A. Hennessy & Hayne E. Leland, 2007. "Can the Trade-off Theory Explain Debt Structure?," Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1389-1428, 2007 04.
    18. David Roubaud & André Lapied & Robert Kast, 2010. "Real Options under Choquet-Brownian Ambiguity," Working Papers halshs-00534027, HAL.
    19. Daniel Ellsberg, 1961. "Risk, Ambiguity, and the Savage Axioms," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 75(4), pages 643-669.
    20. Anderson, Evan W. & Ghysels, Eric & Juergens, Jennifer L., 2009. "The impact of risk and uncertainty on expected returns," Journal of Financial Economics, Elsevier, vol. 94(2), pages 233-263, November.
    21. Bart M. Lambrecht & Stewart C. Myers, 2007. "A Theory of Takeovers and Disinvestment," Journal of Finance, American Finance Association, vol. 62(2), pages 809-845, April.
    22. Jonathan B. Berk, 2004. "Valuation and Return Dynamics of New Ventures," Review of Financial Studies, Society for Financial Studies, vol. 17(1), pages 1-35.
    23. Wong, Kit Pong, 2007. "The effect of uncertainty on investment timing in a real options model," Journal of Economic Dynamics and Control, Elsevier, vol. 31(7), pages 2152-2167, July.
    24. Timothy Cogley & Riccardo Colacito & Lars Peter Hansen & Thomas J. Sargent, 2008. "Robustness and U.S. Monetary Policy Experimentation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(8), pages 1599-1623, December.
    25. Pascal J. Maenhout, 2004. "Robust Portfolio Rules and Asset Pricing," Review of Financial Studies, Society for Financial Studies, vol. 17(4), pages 951-983.
    26. Li-Lin Ku & Chien-Pai Han, 2008. "Robust testing procedures of process locations," Quality & Quantity: International Journal of Methodology, Springer, vol. 42(5), pages 579-595, October.
    27. Lars Peter Hansen & Thomas J Sargent, 2014. "A Quartet of Semigroups for Model Specification, Robustness, Prices of Risk, and Model Detection," World Scientific Book Chapters, in: UNCERTAINTY WITHIN ECONOMIC MODELS, chapter 4, pages 83-143, World Scientific Publishing Co. Pte. Ltd..
    28. Robert McDonald & Daniel Siegel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 101(4), pages 707-727.
    29. Sarkar, Sudipto, 2000. "On the investment-uncertainty relationship in a real options model," Journal of Economic Dynamics and Control, Elsevier, vol. 24(2), pages 219-225, February.
    30. Guthrie, Graeme, 2012. "Uncertainty and the trade-off between scale and flexibility in investment," Journal of Economic Dynamics and Control, Elsevier, vol. 36(11), pages 1718-1728.
    31. Lars Peter Hansen & Thomas J. Sargent, 2008. "Time Inconsistency of Robust Control?," Chapters, in: Roger E.A. Farmer (ed.), Macroeconomics in the Small and the Large, chapter 7, Edward Elgar Publishing.
    32. Jean-Paul Décamps & Thomas Mariotti & Stéphane Villeneuve, 2005. "Investment Timing Under Incomplete Information," Mathematics of Operations Research, INFORMS, vol. 30(2), pages 472-500, May.
    33. Merton, Robert C., 1980. "On estimating the expected return on the market : An exploratory investigation," Journal of Financial Economics, Elsevier, vol. 8(4), pages 323-361, December.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Shuang Li & Haijun Wang, 2023. "Robust irreversible investment strategy with ambiguity to jump and diffusion risk," International Review of Finance, International Review of Finance Ltd., vol. 23(3), pages 645-665, September.
    2. Li, Bin & Li, Danping & Xiong, Dewen, 2016. "Alpha-robust mean-variance reinsurance-investment strategy," Journal of Economic Dynamics and Control, Elsevier, vol. 70(C), pages 101-123.
    3. Yoshioka, Hidekazu & Yaegashi, Yuta, 2019. "A finite difference scheme for variational inequalities arising in stochastic control problems with several singular control variables," Mathematics and Computers in Simulation (MATCOM), Elsevier, vol. 156(C), pages 40-66.
    4. Zhao, Siqi, 2022. "Robust contracting and corporate-termism," Economics Letters, Elsevier, vol. 213(C).
    5. Pengfei Luo & Yong Ma, 2021. "Robustly dynamic tax evasion and consumption with preferences for cash," International Review of Finance, International Review of Finance Ltd., vol. 21(3), pages 1078-1088, September.
    6. Misheck Mutize & Sean J. Gossel, 2019. "Sovereign Credit Rating Announcement Effects on Foreign Currency Denominated Bond and Equity Markets in Africa," Journal of African Business, Taylor & Francis Journals, vol. 20(1), pages 135-152, January.
    7. Ma, Jinrun & Wu, Yaoyao & Liang, Yongtang, 2023. "Robust investment and hedging policy with limited commitment," Economic Modelling, Elsevier, vol. 125(C).
    8. Luo, Pengfei & Tian, Yuan, 2022. "Investment, payout, and cash management under risk and ambiguity," Journal of Banking & Finance, Elsevier, vol. 141(C).

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. So, Leh-chyan, 2013. "Are Real Options “Real”? Isolating Uncertainty from Risk in Real Options Analysis," MPRA Paper 52493, University Library of Munich, Germany.
    2. Shuang Li & Haijun Wang, 2023. "Robust irreversible investment strategy with ambiguity to jump and diffusion risk," International Review of Finance, International Review of Finance Ltd., vol. 23(3), pages 645-665, September.
    3. Massimo Guidolin & Francesca Rinaldi, 2013. "Ambiguity in asset pricing and portfolio choice: a review of the literature," Theory and Decision, Springer, vol. 74(2), pages 183-217, February.
    4. Aït-Sahalia, Yacine & Matthys, Felix, 2019. "Robust consumption and portfolio policies when asset prices can jump," Journal of Economic Theory, Elsevier, vol. 179(C), pages 1-56.
    5. Yacine Aït-Sahalia & Felix Matthys & Emilio Osambela & Ronnie Sircar, 2021. "When Uncertainty and Volatility Are Disconnected: Implications for Asset Pricing and Portfolio Performance," NBER Working Papers 29195, National Bureau of Economic Research, Inc.
    6. Agarwal, Vikas & Arisoy, Y. Eser & Naik, Narayan Y., 2017. "Volatility of aggregate volatility and hedge fund returns," Journal of Financial Economics, Elsevier, vol. 125(3), pages 491-510.
    7. Zhao, Guihai, 2017. "Confidence, bond risks, and equity returns," Journal of Financial Economics, Elsevier, vol. 126(3), pages 668-688.
    8. Asano, Takao & Shibata, Akihisa, 2011. "Optimal pricing and quality choice of a monopolist under Knightian uncertainty," International Journal of Industrial Organization, Elsevier, vol. 29(6), pages 746-754.
    9. Ulrich, Maxim, 2013. "Inflation ambiguity and the term structure of U.S. Government bonds," Journal of Monetary Economics, Elsevier, vol. 60(2), pages 295-309.
    10. Álvaro Cartea & Sebastian Jaimungal, 2017. "Irreversible Investments And Ambiguity Aversion," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 20(07), pages 1-26, November.
    11. Jang, Bong-Gyu & Lee, Seungkyu & Lim, Byung Hwa, 2016. "Robust consumption and portfolio rules with time-varying model confidence," Finance Research Letters, Elsevier, vol. 18(C), pages 342-352.
    12. Wei, Pengyu & Yang, Charles & Zhuang, Yi, 2023. "Robust consumption and portfolio choice with derivatives trading," European Journal of Operational Research, Elsevier, vol. 304(2), pages 832-850.
    13. Hansen, Lars Peter & Sargent, Thomas J., 2011. "Robustness and ambiguity in continuous time," Journal of Economic Theory, Elsevier, vol. 146(3), pages 1195-1223, May.
    14. Guan, Guohui & Hu, Jiaqi & Liang, Zongxia, 2022. "Robust equilibrium strategies in a defined benefit pension plan game," Insurance: Mathematics and Economics, Elsevier, vol. 106(C), pages 193-217.
    15. Jianjun Miao & Alejandro Rivera, 2016. "Robust Contracts in Continuous Time," Econometrica, Econometric Society, vol. 84, pages 1405-1440, July.
    16. Jang, Bong-Gyu & Park, Seyoung, 2016. "Ambiguity and optimal portfolio choice with Value-at-Risk constraint," Finance Research Letters, Elsevier, vol. 18(C), pages 158-176.
    17. M. Trojanowska & P. M. Kort, 2010. "The Worst Case for Real Options," Journal of Optimization Theory and Applications, Springer, vol. 146(3), pages 709-734, September.
    18. Xin Li & Borghan N. Narajabad & Ted Temzelides, 2014. "Robust Dynamic Optimal Taxation and Environmental Externalities," Finance and Economics Discussion Series 2014-75, Board of Governors of the Federal Reserve System (U.S.).
    19. Li, Tongtong & Wang, Shibo & Yang, Jinqiang, 2021. "Robust consumption and portfolio choices with habit formation," Economic Modelling, Elsevier, vol. 98(C), pages 227-246.
    20. Ma, Jinrun & Niu, Yingjie, 2019. "The timing and intensity of investment under ambiguity," The North American Journal of Economics and Finance, Elsevier, vol. 49(C), pages 318-330.

    More about this item

    Keywords

    Real options; Ambiguity; Risk/uncertainty effects; Correlation effects; Investment timing;
    All these keywords.

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:dyncon:v:51:y:2015:i:c:p:278-298. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/jedc .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.