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Risk, Uncertainty, and Option Exercise

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  • Jianjun Miao

    (Institute for Economic Development, Boston University)

  • Neng Wang

    (University of Rochester)

Abstract

Many economic decisions can be described as an option exercise or optimal stopping problem under uncertainty. Motivated by experimental evidence such as the Ellsberg Paradox, we follow Knight (1921) and distinguish risk from uncertainty. To afford this distinction, we adopt the multiple-priors utility model. We show that the impact of ambiguity on the option exercise decision depends on the relative degrees of ambiguity about continuation payoffs and termination payoffs. Consequently, ambiguity may accelerate or delay option exercise. We apply our results to investment and exit problems, and show that the myopic NPV rule can be optimal for an agent having an extremely high degree of ambiguity aversion.
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Suggested Citation

  • Jianjun Miao & Neng Wang, 2004. "Risk, Uncertainty, and Option Exercise," Boston University - Department of Economics - The Institute for Economic Development Working Papers Series dp-136, Boston University - Department of Economics.
    • Handle: RePEc:bos:iedwpr:dp-136
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    File URL: http://www.bu.edu/econ/ied/dp/papers/dp136Miao.pdf
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    More about this item

    Keywords

    Knightian undertainty; multiple-priors utility; real options; optimal stopping problem;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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