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Risk, Uncertainty, and Option Exercise

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Listed author(s):
  • 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 capture 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.

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

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File URL: http://www.bu.edu/econ/ied/dp/papers/dp136Miao.pdf
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Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - The Institute for Economic Development Working Papers Series with number dp-136.

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Length: 30 pages
Date of creation: Jan 2004
Handle: RePEc:bos:iedwpr:dp-136
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Keywords: Knightian undertainty; multiple-priors utility; real options; optimal stopping problem;

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Find related papers by JEL classification:
  • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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