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Incomplete markets, ambiguity, and irreversible investment

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  • Thijssen, Jacco J.J.

Abstract

The problem of irreversible investment with idiosyncratic risk is studied by interpreting market incompleteness as a source of ambiguity over the appropriate no-arbitrage discount factor. The maxmin utility over multiple priors framework is used to model and solve the irreversible investment problem. Multiple priors are modeled using the notion of [kappa][hyphen (true graphic)]ignorance. This set-up is used to analyze finitely lived options. For infinitely lived options the notion of constant [kappa][hyphen (true graphic)]ignorance is introduced. For these sets of density generators the corresponding optimal stopping problem is solved for general (in-)finite horizon optimal stopping problems driven by geometric Brownian motion. It is argued that an increase in the set of priors delays investment, whereas an increase in the degree of market completeness can have a non-monotonic effect on investment.

Suggested Citation

  • Thijssen, Jacco J.J., 2011. "Incomplete markets, ambiguity, and irreversible investment," Journal of Economic Dynamics and Control, Elsevier, vol. 35(6), pages 909-921, June.
  • Handle: RePEc:eee:dyncon:v:35:y:2011:i:6:p:909-921
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    References listed on IDEAS

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    1. Jacco Thijssen, 2010. "Irreversible investment and discounting: an arbitrage pricing approach," Annals of Finance, Springer, vol. 6(3), pages 295-315, July.
    2. Alvarez, Luis H. R. & Keppo, Jussi, 2002. "The impact of delivery lags on irreversible investment under uncertainty," European Journal of Operational Research, Elsevier, vol. 136(1), pages 173-180, January.
    3. Nishimura, Kiyohiko G. & Ozaki, Hiroyuki, 2007. "Irreversible investment and Knightian uncertainty," Journal of Economic Theory, Elsevier, vol. 136(1), pages 668-694, September.
    4. Zengjing Chen & Larry Epstein, 2002. "Ambiguity, Risk, and Asset Returns in Continuous Time," Econometrica, Econometric Society, vol. 70(4), pages 1403-1443, July.
    5. Sarkar, Sudipto, 2000. "On the investment-uncertainty relationship in a real options model," Journal of Economic Dynamics and Control, Elsevier, vol. 24(2), pages 219-225, February.
    6. Miao, Jianjun & Wang, Neng, 2007. "Investment, consumption, and hedging under incomplete markets," Journal of Financial Economics, Elsevier, vol. 86(3), pages 608-642, December.
    7. Hugonnier, Julien & Morellec, Erwan, 2007. "Corporate control and real investment in incomplete markets," Journal of Economic Dynamics and Control, Elsevier, vol. 31(5), pages 1781-1800, May.
    8. Gryglewicz, Sebastian & Huisman, Kuno J.M. & Kort, Peter M., 2008. "Finite project life and uncertainty effects on investment," Journal of Economic Dynamics and Control, Elsevier, vol. 32(7), pages 2191-2213, July.
    9. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
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