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Investment decisions under incomplete markets in the presence of wealth effects

Author

Listed:
  • Yingjie Niu

    (Shanghai University)

  • Jinqiang Yang

    (Shanghai University of Finance and Economics)

  • Zhentao Zou

    (Wuhan University)

Abstract

This paper investigates the impact of market incompleteness on investment decisions. In contrast to previous studies, we assume an entrepreneur has power utility and investment causes an additive increase in her wealth. By using the binomial theorem, we derive the analytical solutions for the option value and investment threshold. First, we show that an increase in wealth alleviates the over-investment problem caused by the market incompleteness. In addition, the marginal value of wealth is always more than one and decreases in the wealth level. Finally, the increase in wealth substantially enhances the value of the investment option and lowers the idiosyncratic risk premium.

Suggested Citation

  • Yingjie Niu & Jinqiang Yang & Zhentao Zou, 2021. "Investment decisions under incomplete markets in the presence of wealth effects," Journal of Economics, Springer, vol. 133(2), pages 167-189, July.
    • Handle: RePEc:kap:jeczfn:v:133:y:2021:i:2:d:10.1007_s00712-021-00731-1
    DOI: 10.1007/s00712-021-00731-1
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    References listed on IDEAS

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    More about this item

    Keywords

    Real options; Power utility; Additive structure; Wealth effects; Incomplete markets;
    All these keywords.

    JEL classification:

    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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