How to analyze the investment–uncertainty relationship in real option models?
AbstractThe real options tradition originally predicted a decreasing relationship between uncertainty and investment, through the positive effect of higher uncertainty on the trigger level for revenue relative to costs. An opposing effect on the probability of reaching the level has been identified, yielding a total effect with ambiguous sign. This paper makes three points. The “opposing” effect is not always opposing. Systematic risk cannot generally be assumed to increase with volatility. A probability is not the best measure of investment. The sign of the total effect is again ambiguous. This ambiguity is illustrated, depending on specification of model and parameters.
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Bibliographic InfoPaper provided by Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics in its series EPRU Working Paper Series with number 03-17.
Length: 21 pages
Date of creation: Nov 2003
Date of revision:
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investment; uncertainty; real options; stochastic control;
Other versions of this item:
- Lund, Diderik, 2005. "How to analyze the investment-uncertainty relationship in real option models?," Review of Financial Economics, Elsevier, vol. 14(3-4), pages 311-322.
- C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
- D92 - Microeconomics - - Intertemporal Choice - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
- E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Capital; Investment; Capacity
- G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
This paper has been announced in the following NEP Reports:
- NEP-ALL-2003-11-30 (All new papers)
- NEP-CFN-2003-11-30 (Corporate Finance)
- NEP-RMG-2003-11-30 (Risk Management)
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