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Irreversible investment in stochastically cyclical markets

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  • 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. Robert E. Lucas, Jr., 1971. "Optimal Management of a Research and Development Project," Management Science, INFORMS, vol. 17(11), pages 679-697, July.
  2. 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.
  3. Xia Su & Frank Riedel, 2006. "On Irreversible Investment," Bonn Econ Discussion Papers bgse13_2006, University of Bonn, Germany.
  4. repec:att:wimass:9504 is not listed on IDEAS
  5. Ben S. Bernanke, 1980. "Irreversibility, Uncertainty, and Cyclical Investment," NBER Working Papers 0502, National Bureau of Economic Research, Inc.
  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. 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.
  8. Guiseppe Moscarini & Francesco Squintani, 2004. "Competitive Experimentation with Private Information," Cowles Foundation Discussion Papers 1489, Cowles Foundation for Research in Economics, Yale University.
  9. 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.
  10. Pindyck, Robert S., 1990. "Irreversibility, uncertainty, and investment," Working papers 3137-90., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  11. 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.
  12. Decamps, Jean-Paul & Mariotti, Thomas, 2004. "Investment timing and learning externalities," Journal of Economic Theory, Elsevier, vol. 118(1), pages 80-102, September.
  13. Xin Guo & Jianjun Miao & Erwan Morellec, 2002. "Irreversible Investment with Regime Shifts," FAME Research Paper Series rp99, International Center for Financial Asset Management and Engineering.
  14. Dixit, Avinash K, 1989. "Entry and Exit Decisions under Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 97(3), pages 620-38, June.
  15. Godfrey Keller & Martin Cripps, 2003. "Strategic Experimentation with Exponential Bandits," Economics Series Working Papers 143, University of Oxford, Department of Economics.
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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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