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Irreversible investment under interest rate variability: new results

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  • Alvarez, Luis H.R.

    (Turku School of Economics and Business Administration)

  • Koskela , Erkki

    ()
    (University of Helsinki, Finland and the Research Department of the Bank of Finland)

Abstract

The current literature on irreversible investment decisions usually makes the assumption of a constant interest rate. We study the impact of interest rate and revenue variability on the decision to carry out an irreversible investment project. Given the generality of the valuation problem considered, we first provide a thorough mathematical characterization of the two-dimensional optimal stopping problem and develop some new results. We establish that interest rate variability has a profound decelerating or accelerating impact on investment demand depending on whether the current interest rate is below or above the long run steady state interest rate, and that its quantitative size may be very large. Allowing for interest rate uncertainty is shown to decelerate rational investment demand by raising both the required exercise premium of the irreversible investment opportunity and the value of waiting. Finally, we demonstrate that increased revenue volatility strengthens the negative impact of interest rate uncertainty and vice versa.

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File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0329.pdf
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Bibliographic Info

Paper provided by Bank of Finland in its series Research Discussion Papers with number 29/2003.

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Length: 32 pages
Date of creation: 12 Nov 2003
Date of revision:
Handle: RePEc:hhs:bofrdp:2003_029

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Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/
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Keywords: irreversible investment; variable interest rates; free boundary problems;

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References

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  2. Giuseppe Bertola & Ricardo J. Caballero, 1991. "Irreversibility and Aggregate Investment," NBER Working Papers 3865, National Bureau of Economic Research, Inc.
  3. Luis H. R. Alvarez & Erkki Koskela, 2001. "Wicksellian Theory of Forest Rotation under Interest Rate Variability," CESifo Working Paper Series 606, CESifo Group Munich.
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Cited by:
  1. Luis H. R. Alvarez & Erkki Koskela, 2001. "Wicksellian Theory of Forest Rotation under Interest Rate Variability," CESifo Working Paper Series 606, CESifo Group Munich.

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