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Investment, Consumption and Hedging under Incomplete Markets

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Author Info
Junjian Miao () (Department of Economics, Boston University)
Neng Wang () (Columbia Business School)

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

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Find related papers by JEL classification:
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy
E2 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment

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References listed on IDEAS
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Dirk Hackbarth & Jianjun Maio, 2007. "The Dynamics of Mergers and Acquisitions in Oligopolistic Industries," Boston University - Department of Economics - Working Papers Series WP2007-017, Boston University - Department of Economics. [Downloadable!]
  2. Hui Chen & Jianjun Miao & Neng Wang, 2009. "Entrepreneurial Finance and Non-diversifiable Risk," NBER Working Papers 14848, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  3. Jean-Paul Décamps & Stéphane Villeneuve, 2007. "Optimal dividend policy and growth option," Finance and Stochastics, Springer, vol. 11(1), pages 3-27, January. [Downloadable!] (restricted)
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