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Risk, Uncertainty, and Option Exercise

  • Jianjun Miao

    ()

    (Department of Economics, Boston University and Department of Finance, the Hong Kong University of Science and Technology)

  • Neng Wang

    ()

    (Columbia Business School)

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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Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - Working Papers Series with number WP2007-016.

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Length: 38pages
Date of creation: Mar 2007
Date of revision:
Handle: RePEc:bos:wpaper:wp2007-016
Contact details of provider: Postal: 270 Bay State Road, Boston, MA 02215
Phone: 617-353-4389
Fax: 617-353-4449
Web page: http://www.bu.edu/econ/

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