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Explicit investment rules with time-to-build and uncertainty

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  • Ren\'e Aid
  • Salvatore Federico
  • Huy\^en Pham
  • Bertrand Villeneuve

Abstract

We establish explicit socially optimal rules for an irreversible investment deci- sion with time-to-build and uncertainty. Assuming a price sensitive demand function with a random intercept, we provide comparative statics and economic interpreta- tions for three models of demand (arithmetic Brownian, geometric Brownian, and the Cox-Ingersoll-Ross). Committed capacity, that is, the installed capacity plus the in- vestment in the pipeline, must never drop below the best predictor of future demand, minus two biases. The discounting bias takes into account the fact that investment is paid upfront for future use; the precautionary bias multiplies a type of risk aversion index by the local volatility. Relying on the analytical forms, we discuss in detail the economic effects.

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Paper provided by arXiv.org in its series Papers with number 1406.0055.

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Date of creation: May 2014
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Handle: RePEc:arx:papers:1406.0055

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  1. Pacheco-de-Almeida, Goncalo & Zemsky, Peter, 2003. " The Effect of Time-to-Build on Strategic Investment under Uncertainty," RAND Journal of Economics, The RAND Corporation, vol. 34(1), pages 166-82, Spring.
  2. Bar-Ilan, Avner & Strange, William C, 1996. "Investment Lags," American Economic Review, American Economic Association, American Economic Association, vol. 86(3), pages 610-22, June.
  3. Bar-Ilan, Avner & Sulem, Agnes & Zanello, Alessandro, 2002. "Time-to-build and capacity choice," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 26(1), pages 69-98, January.
  4. Giorgio Ferrari, 2012. "On an Integral Equation for the Free-Boundary of Stochastic, Irreversible Investment Problems," Papers 1211.0412, arXiv.org, revised Jul 2013.
  5. Felipe L. Aguerrevere, 2003. "Equilibrium Investment Strategies and Output Price Behavior: A Real-Options Approach," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 16(4), pages 1239-1272.
  6. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 101(4), pages 707-27, November.
  7. Steven R. Grenadier, 2002. "Option Exercise Games: An Application to the Equilibrium Investment Strategies of Firms," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 15(3), pages 691-721.
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