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Risk, Uncertainty, and Option Exercise

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Author Info
Jianjun Miao () (Department of Economics, Boston University and Department of Finance, the Hong Kong University of Science and Technology)
Neng Wang () (Columbia Business School)

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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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Publisher 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
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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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Find related papers by JEL classification:
D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy

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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. 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. [Downloadable!]
  2. Jianjun Miao & Neng Wang, 2004. "Investment, Hedging, and Consumption Smoothing," Finance 0407014, EconWPA. [Downloadable!]
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