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Investment, Consumption and Hedging under Incomplete Markets

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  • Junjian Miao

    ()
    (Department of Economics, Boston University)

  • Neng Wang

    ()
    (Columbia Business School)

Abstract

Entrepreneurs often face undiversi¯able idiosyncratic risks from their business invest- ments. Motivated by this observation, we extend the standard real options approach to investment to an incomplete markets environment and analyze the joint decisions of busi- ness investments, consumption-saving and portfolio selection. Our analysis depends cru- cially on whether the investment payo®s are in lump-sum or in °ows. Precautionary saving e®ect plays a key role. In the lump-sum payo® case, risk aversion accelerates investment. Moreover, when the agent's precautionary motive is strong enough, an increase in volatility accelerates investment. These results may be reversed for the °ow payo® case. Finally, hedging a®ects investment decisions by changing the expected growth of wealth and reduc- ing the agent's exposure to idiosyncratic risk. The agent's hedging demand is higher when he is closer to exercising the investment option.

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Bibliographic Info

Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - Macroeconomics Working Papers Series with number WP2005-011.

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Length: 42 pages
Date of creation: Oct 2005
Date of revision: Sep 2006
Publication status: published, Journal of Financial Economics 86 (2007), 608-642
Handle: RePEc:bos:macppr:wp2005-011

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Keywords: real options; idiosyncratic risk; hedging; risk aversion; precautionary saving; incomplete markets;

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