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Risk, Uncertainty, and Option Exercise

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  • Jianjun Miao

    ()
    (Department of Economics, Boston University and Department of Finance, the Hong Kong University of Science and Technology)

  • Neng Wang

    ()
    (Columbia Business School)

Abstract

Many economic decisions can be described as an option exercise or optimal stopping problem under uncertainty. Motivated by experimental evidence such as the Ellsberg Paradox, we follow Knight (1921) and distinguish risk from uncertainty. To afford 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, ambiguity 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 - Working Papers Series with number WP2007-016.

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Length: 38pages
Date of creation: Mar 2007
Date of revision:
Handle: RePEc:bos:wpaper:wp2007-016

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Keywords: industry ambiguity; 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. Massimo Guidolin & Francesca Rinaldi, 2011. "Ambiguity in Asset Pricing and Portfolio Choice: A Review of the Literature," Working Papers 417, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  2. So, Leh-chyan, 2013. "Are Real Options “Real”? Isolating Uncertainty from Risk in Real Options Analysis," MPRA Paper 52493, University Library of Munich, Germany.
  3. Zimper, Alexander, 2012. "Asset pricing in a Lucas fruit-tree economy with the best and worst in mind," Journal of Economic Dynamics and Control, Elsevier, vol. 36(4), pages 610-628.
  4. In-Koo Cho & Kenneth Kasa, 2013. "An Escape Time Interpretation of Robust Control," Discussion Papers dp13-07, Department of Economics, Simon Fraser University.
  5. Ling, Aifan & Sun, Jie & Yang, Xiaoguang, 2014. "Robust tracking error portfolio selection with worst-case downside risk measures," Journal of Economic Dynamics and Control, Elsevier, vol. 39(C), pages 178-207.
  6. Tamini, Lota Dabio, 2012. "Optimal quality choice under uncertainty on market development," Working Papers 148589, Structure and Performance of Agriculture and Agri-products Industry (SPAA).
  7. 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.
  8. 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.
  9. Ulrich, Maxim, 2013. "Inflation ambiguity and the term structure of U.S. Government bonds," Journal of Monetary Economics, Elsevier, vol. 60(2), pages 295-309.
  10. Tamini, Lota D., 2012. "Optimal quality choice under uncertainty on market development," MPRA Paper 40845, University Library of Munich, Germany.
  11. Jianjun Miao & Neng Wang, 2004. "Investment, Hedging, and Consumption Smoothing," Finance 0407014, EconWPA.
  12. 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.
  13. 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.
  14. Takanori Adachi & Takao Asano, 2011. "Entrepreneurial Choice and Knightian Uncertainty with Borrowing Constraints," KIER Working Papers 803, Kyoto University, Institute of Economic Research.

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