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Investment, Consumption, and Hedging under Incomplete Markets

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Jianjun Miao
Neng Wang

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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 the joint decisions of business investments, consumption/savings, and portfolio selection. For a lump-sum investment payoff and an agent with a sufficiently 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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13250.

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Date of creation: Jul 2007
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Handle: RePEc:nbr:nberwo:13250

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Find related papers by JEL classification:
E2 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy

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Cited by:
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  1. Dirk Hackbarth & Jianjun Maio, 2007. "The Dynamics of Mergers and Acquisitions in Oligopolistic Industries," Boston University - Department of Economics - Working Papers Series WP2007-017, Boston University - Department of Economics. [Downloadable!]
  2. Jean-Paul Décamps & Stéphane Villeneuve, 2007. "Optimal dividend policy and growth option," Finance and Stochastics, Springer, vol. 11(1), pages 3-27, January. [Downloadable!] (restricted)
  3. Hui Chen & Jianjun Miao & Neng Wang, 2009. "Entrepreneurial Finance and Non-diversifiable Risk," NBER Working Papers 14848, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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