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Irreversible investment in stochastically cyclical markets

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Author Info

  • Francisco Ruiz-Aliseda
  • Jianjun Wu

Abstract

This 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 Info

Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 1018.

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Date of creation: Mar 2007
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Handle: RePEc:upf:upfgen:1018

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Web page: http://www.econ.upf.edu/

Related research

Keywords: Real Options; Regime-Switching; Bad News Principle; Signal Extraction Problem; Entry and Exit; Industry Life Cycles;

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References

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  1. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, vol. 101(4), pages 707-27, November.
  2. Pindyck, Robert S, 1991. "Irreversibility, Uncertainty, and Investment," Journal of Economic Literature, American Economic Association, vol. 29(3), pages 1110-48, September.
  3. Kyle Bagwell & Robert W. Staiger, 1995. "Collusion Over the Business Cycle," Discussion Papers 1118, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  4. Dixit, A., 1988. "Entry And Exit Decisions Under Uncertainty," Papers 91, Princeton, Department of Economics - Financial Research Center.
  5. Abel, Andrew B & Eberly, Janice C, 1996. "Optimal Investment with Costly Reversibility," Review of Economic Studies, Wiley Blackwell, vol. 63(4), pages 581-93, October.
  6. Ron Adner & Peter Zemsky, 2005. "Disruptive Technologies and the Emergence of Competition," RAND Journal of Economics, The RAND Corporation, vol. 36(2), pages 229-254, Summer.
  7. Cripps, Martin & Keller, Godfrey & Rady, Sven, 2003. "Strategic Experimentation with Exponential Bandits," Discussion Papers in Economics 4, University of Munich, Department of Economics.
  8. Guo, Xin & Miao, Jianjun & Morellec, Erwan, 2005. "Irreversible investment with regime shifts," Journal of Economic Theory, Elsevier, vol. 122(1), pages 37-59, May.
  9. Xia Su & Frank Riedel, 2006. "On Irreversible Investment," Bonn Econ Discussion Papers bgse13_2006, University of Bonn, Germany.
  10. Driffill John & Raybaudi Marzia & Sola Martin, 2003. "Investment Under Uncertainty with Stochastically Switching Profit Streams: Entry and Exit over the Business Cycle," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 7(1), pages 1-40, April.
  11. Robert E. Lucas, Jr., 1971. "Optimal Management of a Research and Development Project," Management Science, INFORMS, vol. 17(11), pages 679-697, July.
  12. Guiseppe Moscarini & Francesco Squintani, 2004. "Competitive Experimentation with Private Information," Cowles Foundation Discussion Papers 1489, Cowles Foundation for Research in Economics, Yale University.
  13. Ben S. Bernanke, 1980. "Irreversibility, Uncertainty, and Cyclical Investment," NBER Working Papers 0502, National Bureau of Economic Research, Inc.
  14. Decamps, Jean-Paul & Mariotti, Thomas, 2004. "Investment timing and learning externalities," Journal of Economic Theory, Elsevier, vol. 118(1), pages 80-102, September.
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Citations

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Cited by:
  1. Oscar Gutiérrez & Francisco Ruiz-Aliseda, 2011. "Real options with unknown-date events," Annals of Finance, Springer, vol. 7(2), pages 171-198, May.
  2. Talat S. Genc & Georges Zaccour, 2010. "Investment Dynamics: Good News Principle," Working Papers 1006, University of Guelph, Department of Economics and Finance.

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