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Irreversible Investment under Interest Rate Variability: Some Generalizations

Author

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  • Luis H. R. Alvarez

    (Turku School of Economics and Business Administration)

  • Erkki Koskela

    (University of Helsinki, Bank of Finland, Center for Economic Studies—IFO, and Institute for the Study of Labor)

Abstract

We study the impact of interest rate and revenue variability on the decision to carry out irreversible investment. We provide a mathematical characterization of the two-dimensional optimal stopping problem and show that interest rate variability has a decelerating or accelerating impact on investment depending on whether the current interest rate is below or above the long-run steady state. Allowing for interest rate volatility decelerates investment by raising both the required exercise premium of the investment opportunity and the value of waiting. Finally, increased revenue volatility is shown to strengthen the negative impact of interest rate volatility and vice versa.

Suggested Citation

  • Luis H. R. Alvarez & Erkki Koskela, 2006. "Irreversible Investment under Interest Rate Variability: Some Generalizations," The Journal of Business, University of Chicago Press, vol. 79(2), pages 623-644, March.
    • Handle: RePEc:ucp:jnlbus:v:79:y:2006:i:2:p:623-644
    DOI: 10.1086/499133
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    Cited by:

    1. Alvarez, Luis H. R. & Koskela, Erkki, 2005. "Wicksellian theory of forest rotation under interest rate variability," Journal of Economic Dynamics and Control, Elsevier, vol. 29(3), pages 529-545, March.
    2. Carmona, Julio & Leon, Angel, 2007. "Investment option under CIR interest rates," Finance Research Letters, Elsevier, vol. 4(4), pages 242-253, December.
    3. Luis Alvarez, 2010. "Irreversible capital accumulation under interest rate uncertainty," Mathematical Methods of Operations Research, Springer;Gesellschaft für Operations Research (GOR);Nederlands Genootschap voor Besliskunde (NGB), vol. 72(2), pages 249-271, October.
    4. Luis H.R. Alvarez E., 2006. "Irreversible Investment, Incremental Capital Accumulation, and Price Uncertainty," Discussion Papers 4, Aboa Centre for Economics.
    5. Nesrine Dardouri & Abdelkader Aguir & Ramzi Farhani & Mounir Smida, 2023. "Revisiting the Determinants of Investment- The Case of Tunisia," Post-Print hal-04101430, HAL.
    6. Godwin Olasehinde-Williams & Oktay Özkan, 2022. "Is interest rate uncertainty a predictor of investment volatility? evidence from the wild bootstrap likelihood ratio approach," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 46(3), pages 507-521, July.
    7. Dias, José Carlos & Shackleton, Mark B., 2011. "Hysteresis effects under CIR interest rates," European Journal of Operational Research, Elsevier, vol. 211(3), pages 594-600, June.
    8. Luca Vincenzo Ballestra & Graziella Pacelli & Davide Radi, 2017. "Valuing investment projects under interest rate risk: empirical evidence from European firms," Applied Economics, Taylor & Francis Journals, vol. 49(56), pages 5662-5672, December.
    9. Sarkar, Sudipto, 2021. "The uncertainty-investment relationship with endogenous capacity," Omega, Elsevier, vol. 98(C).

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