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Optimal investment timing using Markov jump price processes

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  • Fernando A. C. C. Fonte

    ()
    (Departamento de Matemática para a Ciência e Tecnologia, Universidade do Minho, Portugal)

  • Dalila B. M. M. Fontes

    ()
    (LIAAD and Faculdade de Economia da Universidade do Porto, Portugal)

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    Abstract

    In this work, we address an investment problem where the investment can either be made immediately or postponed to a later time, in the hope that market conditions become more favourable. In our case, uncertainty is introduced through market price. When the investment is undertaken, a fixed sunk cost must be paid and a series of cash flows are to be received. Therefore, we are faced with an irreversible investment. Real options analysis provides an adequate framework for this type of problems by recognizing these two characteristics, uncertainty and irreversibility, explicitly. We describe algorithmic solutions for this type of problems by modelling market prices evolution by Markov jump processes.

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    File URL: http://www.fep.up.pt/investigacao/workingpapers/07.07.30_wp245_FontesFontes.pdf
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    Bibliographic Info

    Paper provided by Universidade do Porto, Faculdade de Economia do Porto in its series FEP Working Papers with number 245.

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    Length: 25 pages
    Date of creation: Jul 2007
    Date of revision:
    Handle: RePEc:por:fepwps:245

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    Related research

    Keywords: Irreversible investment; optimal stopping; dynamic programming; Markov jump processes;

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    1. Timothy F. Bresnahan & Shane Greenstein, 1997. "Technological Competition and the Structure of the Computer Industry," Working Papers 97028, Stanford University, Department of Economics.
    2. Greenwood, Jeremy & Hercowitz, Zvi & Krusell, Per, 1997. "Long-Run Implications of Investment-Specific Technological Change," American Economic Review, American Economic Association, vol. 87(3), pages 342-62, June.
    3. Galor, O. & Tsiddon, D., 1996. "Technological Progress, Mobility and Economic Growth," Papers 13-96, Tel Aviv.
    4. Sergey Levendorskiy & Svetlana Boyarchenko, 2004. "Practical guide to real options in discrete time," Computing in Economics and Finance 2004 137, Society for Computational Economics.
    5. Boyarchenko, Svetlana & Levendorskii[caron], Sergei, 2007. "Optimal stopping made easy," Journal of Mathematical Economics, Elsevier, vol. 43(2), pages 201-217, February.
    6. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    7. Clark, Ephraim, 1997. "Valuing political risk," Journal of International Money and Finance, Elsevier, vol. 16(3), pages 477-490, June.
    8. Ghemawat, Pankaj & Kennedy, Robert E., 1999. "Competitive shocks and industrial structure: the case of Polish manufacturing," International Journal of Industrial Organization, Elsevier, vol. 17(6), pages 847-867, August.
    9. Martzoukos, Spiros H. & Trigeorgis, Lenos, 2002. "Real (investment) options with multiple sources of rare events," European Journal of Operational Research, Elsevier, vol. 136(3), pages 696-706, February.
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