IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Log in (now much improved!) to save this article

Investment, consumption, and hedging under incomplete markets

  • Miao, Jianjun
  • Wang, Neng

Entrepreneurs often face undiversi¯able idiosyncratic risks from their business invest- ments. Motivated by this observation, we extend the standard real options approach to investment to an incomplete markets environment and analyze the joint decisions of busi- ness investments, consumption-saving and portfolio selection. Our analysis depends cru- cially on whether the investment payo®s are in lump-sum or in °ows. Precautionary saving e®ect plays a key role. In the lump-sum payo® case, risk aversion accelerates investment. Moreover, when the agent's precautionary motive is strong enough, an increase in volatility accelerates investment. These results may be reversed for the °ow payo® case. Finally, hedging a®ects investment decisions by changing the expected growth of wealth and reduc- ing the agent's exposure to idiosyncratic risk. The agent's hedging demand is higher when he is closer to exercising the investment option.

(This abstract was borrowed from another version of this item.)

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.sciencedirect.com/science/article/pii/S0304-405X(07)00122-5
Download Restriction: Full text for ScienceDirect subscribers only

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 86 (2007)
Issue (Month): 3 (December)
Pages: 608-642

as
in new window

Handle: RePEc:eee:jfinec:v:86:y:2007:i:3:p:608-642
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505576

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Hayne E. Leland, 1968. "Saving and Uncertainty: The Precautionary Demand for Saving," The Quarterly Journal of Economics, Oxford University Press, vol. 82(3), pages 465-473.
  2. Matthias Kahl & Jun Liu & Francis A. Longstaff, 2002. "Paper millionaires: How valuable is stock to a stockholder who is restricted from selling it?," NBER Working Papers 8969, National Bureau of Economic Research, Inc.
  3. 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.
  4. Milton Friedman, 1957. "A Theory of the Consumption Function," NBER Books, National Bureau of Economic Research, Inc, number frie57-1, September.
  5. Miles S. Kimball, 1989. "Precautionary Saving in the Small and in the Large," NBER Working Papers 2848, National Bureau of Economic Research, Inc.
  6. Caballero, Ricardo J, 1991. "Earnings Uncertainty and Aggregate Wealth Accumulation," American Economic Review, American Economic Association, vol. 81(4), pages 859-71, September.
  7. Ben S. Bernanke, 1983. "Irreversibility, Uncertainty, and Cyclical Investment," The Quarterly Journal of Economics, Oxford University Press, vol. 98(1), pages 85-106.
  8. Titman, Sheridan, 1985. "Urban Land Prices under Uncertainty," American Economic Review, American Economic Association, vol. 75(3), pages 505-14, June.
  9. Guiseppe Bertola & Ricardo J. Caballero, 1994. "Irreversibility and Aggregate Investment," Review of Economic Studies, Oxford University Press, vol. 61(2), pages 223-246.
  10. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-57, April.
  11. Alberto Moel, 2002. "When Are Real Options Exercised? An Empirical Study of Mine Closings," Review of Financial Studies, Society for Financial Studies, vol. 15(1), pages 35-64, March.
  12. Steven R. Grenadier & Neng Wang, 2005. "Investment Timing, Agency, and Information," NBER Working Papers 11148, National Bureau of Economic Research, Inc.
  13. Dumas, Bernard, 1991. "Super contact and related optimality conditions," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 675-685, October.
  14. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711, March.
  15. William M. Gentry & R. Glenn Hubbard, 2000. "Entrepreneurship and Household Saving," NBER Working Papers 7894, National Bureau of Economic Research, Inc.
  16. Quigg, Laura, 1993. " Empirical Testing of Real Option-Pricing Models," Journal of Finance, American Finance Association, vol. 48(2), pages 621-40, June.
  17. Robert S. Pindyck, 1986. "Irreversible Investment, Capacity Choice, and the Value of the Firm," NBER Working Papers 1980, National Bureau of Economic Research, Inc.
  18. John Heaton & Deborah Lucas, 2000. "Portfolio Choice and Asset Prices: The Importance of Entrepreneurial Risk," Journal of Finance, American Finance Association, vol. 55(3), pages 1163-1198, 06.
  19. Davis, Steven J. & Willen, Paul S., 2013. "Occupation-level income shocks and asset returns: their covariance and implications for portfolio choice," Working Papers 13-9, Federal Reserve Bank of Boston, revised 24 Oct 2013.
  20. Gentry William M. & Hubbard R. Glenn, 2004. "Entrepreneurship and Household Saving," The B.E. Journal of Economic Analysis & Policy, De Gruyter, vol. 4(1), pages 1-57, August.
  21. Abel, Andrew B & Eberly, Janice C, 1994. "A Unified Model of Investment under Uncertainty," American Economic Review, American Economic Association, vol. 84(5), pages 1369-84, December.
  22. Kogan, Leonid, 2001. "An equilibrium model of irreversible investment," Journal of Financial Economics, Elsevier, vol. 62(2), pages 201-245, November.
  23. Milton Friedman, 1957. "Introduction to "A Theory of the Consumption Function"," NBER Chapters, in: A Theory of the Consumption Function, pages 1-6 National Bureau of Economic Research, Inc.
  24. Wang, Neng, 2004. "Precautionary saving and partially observed income," Journal of Monetary Economics, Elsevier, vol. 51(8), pages 1645-1681, November.
  25. Hyeng Keun Koo, 1998. "Consumption and Portfolio Selection with Labor Income: A Continuous Time Approach," Mathematical Finance, Wiley Blackwell, vol. 8(1), pages 49-65.
  26. Jérôme B. Detemple & Suresh Sundaresan, 1999. "Non-Traded Asset Valuation with Portfolio Constraints: A Binomial Approach," CIRANO Working Papers 99s-08, CIRANO.
  27. Williams, Joseph T, 1991. "Real Estate Development as an Option," The Journal of Real Estate Finance and Economics, Springer, vol. 4(2), pages 191-208, June.
  28. Grenadier, Steven R, 1996. " The Strategic Exercise of Options: Development Cascades and Overbuilding in Real Estate Markets," Journal of Finance, American Finance Association, vol. 51(5), pages 1653-79, December.
  29. Luis M. Viceira, 1999. "Optimal Portfolio Choice for Long-Horizon Investors with Nontradable Labor Income," NBER Working Papers 7409, National Bureau of Economic Research, Inc.
  30. Kevin J. Murphy & Brian J. Hall, 2000. "Optimal Exercise Prices for Executive Stock Options," American Economic Review, American Economic Association, vol. 90(2), pages 209-214, May.
  31. Berger, Philip G. & Ofek, Eli & Swary, Itzhak, 1996. "Investor valuation of the abandonment option," Journal of Financial Economics, Elsevier, vol. 42(2), pages 257-287, October.
  32. Carpenter, Jennifer N., 1998. "The exercise and valuation of executive stock options," Journal of Financial Economics, Elsevier, vol. 48(2), pages 127-158, May.
  33. 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.
  34. Duffie, Darrell & Fleming, Wendell & Soner, H. Mete & Zariphopoulou, Thaleia, 1997. "Hedging in incomplete markets with HARA utility," Journal of Economic Dynamics and Control, Elsevier, vol. 21(4-5), pages 753-782, May.
  35. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942, December.
  36. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-87, December.
  37. Stephen P. Zeldes, 1989. "Optimal Consumption with Stochastic Income: Deviations from Certainty Equivalence," The Quarterly Journal of Economics, Oxford University Press, vol. 104(2), pages 275-298.
  38. Svensson, L.E. & Werner, I., 1990. "Nontraded Assets in Incomplete Markets: Pricing and Portfolio Choices," Papers 477, Stockholm - International Economic Studies.
  39. Deaton, Angus, 1991. "Saving and Liquidity Constraints," Econometrica, Econometric Society, vol. 59(5), pages 1221-48, September.
  40. Tobias J. Moskowitz & Annette Vissing-Jørgensen, 2002. "The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle?," American Economic Review, American Economic Association, vol. 92(4), pages 745-778, September.
  41. Neng Wang, 2003. "Caballero Meets Bewley: The Permanent-Income Hypothesis in General Equilibrium," American Economic Review, American Economic Association, vol. 93(3), pages 927-936, June.
  42. Detemple, Jerome & Sundaresan, Suresh, 1999. "Nontraded Asset Valuation with Portfolio Constraints: A Binomial Approach," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 835-72.
  43. Caballero, Ricardo J, 1991. "On the Sign of the Investment-Uncertainty Relationship," American Economic Review, American Economic Association, vol. 81(1), pages 279-88, March.
  44. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  45. Wang, Neng, 2006. "Generalizing the permanent-income hypothesis: Revisiting Friedman's conjecture on consumption," Journal of Monetary Economics, Elsevier, vol. 53(4), pages 737-752, May.
  46. John V. Leahy & Toni M. Whited, 1995. "The Effect of Uncertainty on Investment: Some Stylized Facts," NBER Working Papers 4986, National Bureau of Economic Research, Inc.
  47. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-57, August.
  48. Robert McDonald & Daniel Siegel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, Oxford University Press, vol. 101(4), pages 707-727.
  49. Tobias J. Moskowitz & Annette Vissing-Jorgensen, 2002. "The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle?," NBER Working Papers 8876, National Bureau of Economic Research, Inc.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:eee:jfinec:v:86:y:2007:i:3:p:608-642. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Shamier, Wendy)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.