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Investment, Consumption, and Hedging under Incomplete Markets

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  • Jianjun Miao
  • Neng Wang

Abstract

Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. We extend the standard real options approach to an incomplete markets environment and analyze their joint decisions of business investments, consumption/savings, and portfolio selection. For a lump-sum investment payoff and an agent with a su¡Àciently strong precautionary savings motive, an increase in volatility can accelerate investment, contrary to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. Finally, when the investment payoff is a series of flows, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing a reversal of the results in the lump-sum payoff case.

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Bibliographic Info

Paper provided by China Economics and Management Academy, Central University of Finance and Economics in its series CEMA Working Papers with number 459.

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Length: 46 pages
Date of creation: Sep 2006
Date of revision:
Publication status: Published in Journal of Financial Economics 86 (2007), 608-642.
Handle: RePEc:cuf:wpaper:459

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Web page: http://cema.cufe.edu.cn/
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Keywords: real options; idiosyncratic risk; hedging; risk aversion; precautionary savings; incomplete markets;

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