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Risk, Uncertainty, and Option Exercise

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Author Info

  • Jianjun Miao

    () (Institute for Economic Development, Boston University)

  • Neng Wang

    () (University of Rochester)

Abstract

Many economic decisions can be described as an option exercise or optimal stopping problem under uncertainty. Motivated by experimental evidence such ast he Ellsberg Paradox, we follow Knight (1921) and distinguish risk from uncertainty. To capture this distinction, we adopt the multiple-priors utility model. We show that the impact of ambiguity on the option exercise decision depends on the relative degrees of ambiguity about continuation payoffs and termination payoffs. Consequently,a mbiguity may accelerate or delay option exercise. We apply our results to investment and exit problems, and show that the myopic NPV rule can be optimal for an agent having an extremely high degree of ambiguity aversion.

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Bibliographic Info

Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - The Institute for Economic Development Working Papers Series with number dp-136.

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Length: 30 pages
Date of creation: Jan 2004
Date of revision:
Handle: RePEc:bos:iedwpr:dp-136

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Keywords: Knightian undertainty; multiple-priors utility; real options; optimal stopping problem;

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References

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Citations

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Cited by:
  1. Jianjun Miao, 2003. "Consumption and Saving under Knightian Uncertainty," Boston University - Department of Economics - The Institute for Economic Development Working Papers Series dp-134, Boston University - Department of Economics.
  2. Takanori Adachi & Takao Asano, 2011. "Entrepreneurial Choice and Knightian Uncertainty with Borrowing Constraints," KIER Working Papers 803, Kyoto University, Institute of Economic Research.
  3. Zengwu Wang, 2010. "Irreversible Investment of the Risk- and Uncertainty-averse DM under k-Ignorance: The Role of BSDE," Annals of Economics and Finance, Society for AEF, vol. 11(2), pages 313-335, November.
  4. Paul Viefers, 2012. "Should I Stay or Should I Go?: A Laboratory Analysis of Investment Opportunities under Ambiguity," Discussion Papers of DIW Berlin 1228, DIW Berlin, German Institute for Economic Research.
  5. Tamini, Lota D., 2012. "Optimal quality choice under uncertainty on market development," MPRA Paper 40845, University Library of Munich, Germany.
  6. Jianjun Miao & Neng Wang, 2004. "Investment, Hedging, and Consumption Smoothing," Finance 0407014, EconWPA.
  7. Jianjun Miao, 2004. "A Note on Consumption and Savings under Knightian Uncertainty," Annals of Economics and Finance, Society for AEF, vol. 5(2), pages 299-311, November.
  8. Joe Chen & Yun Jeong Choi & Kohta Mori & Yasuyuki Sawada & Saki Sugano, 2009. "Socio-Economic Studies on Suicide: A Survey," CIRJE F-Series CIRJE-F-629, CIRJE, Faculty of Economics, University of Tokyo.

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