Irreversible investment in stochastically cyclical markets
AbstractThis paper presents a new framework for studying irreversible (dis)investment when a market follows a random number of random-length cycles (such as a high-tech product market). It is assumed that a firm facing such market evolution is always unsure about whether the current cycle is the last one, although it can update its beliefs about the probability of facing a permanent decline by observing that no further growth phase arrives. We show that the existence of regime shifts in fluctuating markets suffices for an option value of waiting to (dis)invest to arise, and we provide a marginal interpretation of the optimal (dis)investment policies, absent in the real options literature. The paper also shows that, despite the stochastic process of the underlying variable has a continuous sample path, the discreteness in the regime changes implies that the sample path of the firm’s value experiences jumps whenever the regime switches all of a sudden, irrespective of whether the firm is active or not.
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Bibliographic InfoPaper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 1018.
Date of creation: Mar 2007
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Real Options; Regime-Switching; Bad News Principle; Signal Extraction Problem; Entry and Exit; Industry Life Cycles;
Find related papers by JEL classification:
- D92 - Microeconomics - - Intertemporal Choice - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
- G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
- L12 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Monopoly; Monopolization Strategies
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-03-10 (All new papers)
- NEP-BEC-2007-03-10 (Business Economics)
- NEP-MAC-2007-03-10 (Macroeconomics)
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