Testing the Option Value Theory of Irreversible Investment
AbstractThis paper statistically tests the option theory of irreversible investment under uncertainty. Using contingent claims valuation, we derive the value of options to invest in capacity, where the projects are endogenous to the economic circumstances prevailing at the investment date. We then test whether capacity investment decisions made by Canadian copper mines are compatible with the trigger price implied by the theory. The results speak strongly in favor of option theory as a theory of real investment. Our model explains both investment size and timing satisfactorily, from a statistical, and from an economic, point of view, and numerical simulations with a mean-reverting process suggest that the results do not depend crucially on the price being assumed to follow a geometric Brownian motion. Nous etablissons par la methode des actifs contingents la valeur de l'option d'effectuer des investissements irréversibles réels qui sont sensibles aux paramètres économiques prévalant au moment de la décision. Nous testons ensuite si des mines de cuivre canadiennes choisissent bien d'effectuer leurs investissements en capacité de production au moment où le prix du cuivre atteint le niveau critique impliqué par la théorie. Les résultats sont fortement en faveur de celle-ci. Le modèle explique tant la taille que la date des investissements, d'une manière statistiquement et économiquement satisfaisantes; des simulations avec un processus de retour à la moyenne indiquent que ces résultats ne dépendent pas de façon cruciale de l'hypothèse que le prix suit un processus brownien géométrique.
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Bibliographic InfoPaper provided by Université du Québec à Montréal, Département des sciences économiques in its series Cahiers de recherche du Département des sciences économiques, UQAM with number 9905.
Date of creation: May 1999
Date of revision:
Publication status: published in the International Economic Review, Vol 42, No 1, February 2001, p. 141-166
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Web page: http://www.uqam.ca/economie/
More information through EDIRC
Irreversible Investment; Uncertainty; Contingent Claims; Option Value; Putty Clay; Real Investment; Trigger Price - Investissement irréversible; incertitude; actifs contingents; valeur d'option; investissement réel; prix critique;
Other versions of this item:
- Harchaoui, Tarek M & Lasserre, Pierre, 2001. "Testing the Option Value Theory of Irreversible Investment," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(1), pages 141-66, February.
- Tarek M. Harchaoui & Pierre Lasserre, 1995. "Testing the Option Value Theory of Irreversible Investment," CIRANO Working Papers 95s-41, CIRANO.
- Harchaoui, T. & Lasserre, P., 1995. "Testing the Option Vakue Theory of Irreversible Investment," G.R.E.Q.A.M. 95b04, Universite Aix-Marseille III.
- Tarek M. Harchaoui & Pierre Lasserre, 1999. "Testing the Option Value Theory of Irreversible Investment," CIRANO Working Papers 99s-35, CIRANO.
- D92 - Microeconomics - - Intertemporal Choice - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
- G1 - Financial Economics - - General Financial Markets
- L72 - Industrial Organization - - Industry Studies: Primary Products and Construction - - - Mining, Extraction, and Refining: Other Nonrenewable Resources
- Q31 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Nonrenewable Resources and Conservation - - - Demand and Supply; Prices
This paper has been announced in the following NEP Reports:
- NEP-AGR-1999-04-22 (Agricultural Economics)
- NEP-ALL-1999-04-22 (All new papers)
- NEP-CFN-1999-04-22 (Corporate Finance)
- NEP-ENV-1999-04-22 (Environmental Economics)
- NEP-FIN-1999-04-24 (Finance)
- NEP-IND-1999-04-22 (Industrial Organization)
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