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Risk, uncertainty,and option exercise

Author Info

  • Jianjun Miao

    ()

    (Department of Economics, Boston University, CEMA, Central University of Finance and Economics, and AFR, Zhejiang University)

  • Neng Wang

    ()

    (Columbia Business School and NBER)

Abstract

Many economic decisions can be described as an option exercise or optimal stopping problem under uncertainty. Motivated by experimental evidence such ast he 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,a mbiguity 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 WP2010-029.

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Length: 20 pages
Date of creation: Jan 2010
Date of revision:
Handle: RePEc:bos:wpaper:wp2010-029
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Keywords: Ambiguity; 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
  • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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Cited by:

  1. Leh-Chyan So, 2014. "Are Real Options "Real"? Isolating Uncertainty From Risk In Real Options Analysis," Annals of Financial Economics (AFE), World Scientific Publishing Co. Pte. Ltd., vol. 9(01), pages 1450001-1-1.
  2. Tamini, Lota D., 2012. "Optimal quality choice under uncertainty on market development," MPRA Paper 40845, University Library of Munich, Germany.
  3. Jianjun Miao & Neng Wang, 2004. "Investment, Hedging, and Consumption Smoothing," Finance 0407014, EconWPA.
  4. In-Koo Cho & Kenneth Kasa, 2013. "An Escape Time Interpretation of Robust Control," Discussion Papers dp13-07, Department of Economics, Simon Fraser University.
  5. Tamini, Lota Dabio, 2012. "Optimal quality choice under uncertainty on market development," Working Papers 148589, Structure and Performance of Agriculture and Agri-products Industry (SPAA).
  6. Massimo Guidolin & Francesca Rinaldi, 2011. "Ambiguity in Asset Pricing and Portfolio Choice: A Review of the Literature," Working Papers 417, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  7. Jianjun Miao, 2003. "Consumption and Saving under Knightian Uncertainty," Boston University - Department of Economics - The Institute for Economic Development Working Papers Series dp-134, Boston University - Department of Economics.
  8. Fouilloux, Jessica & Moraux, Franck & Viviani, Jean-Laurent, 2015. "Investing in finite-life carbon emissions reduction program under risk and idiosyncratic uncertainty," Energy Policy, Elsevier, vol. 82(C), pages 310-320.
  9. Zimper, Alexander, 2012. "Asset pricing in a Lucas fruit-tree economy with the best and worst in mind," Journal of Economic Dynamics and Control, Elsevier, vol. 36(4), pages 610-628.
  10. Zengwu Wang, 2010. "Irreversible Investment of the Risk- and Uncertainty-averse DM under k-Ignorance: The Role of BSDE," Annals of Economics and Finance, Society for AEF, vol. 11(2), pages 313-335, November.
  11. Takanori Adachi & Takao Asano, 2011. "Entrepreneurial Choice and Knightian Uncertainty with Borrowing Constraints," KIER Working Papers 803, Kyoto University, Institute of Economic Research.
  12. Sara Amoroso & Pietro Moncada-Paterno-Castello & Antonio Vezzani, 2015. "R&D profitability: the role of risk and Knightian uncertainty," JRC Working Papers on Corporate R&D and Innovation 2015-01, Directorate Growth & Innovation and JRC-Seville, Joint Research Centre.
  13. Ulrich, Maxim, 2013. "Inflation ambiguity and the term structure of U.S. Government bonds," Journal of Monetary Economics, Elsevier, vol. 60(2), pages 295-309.
  14. Ling, Aifan & Sun, Jie & Yang, Xiaoguang, 2014. "Robust tracking error portfolio selection with worst-case downside risk measures," Journal of Economic Dynamics and Control, Elsevier, vol. 39(C), pages 178-207.
  15. Trojani, Fabio & Wiehenkamp, Christian & Wrampelmeyer, Jan, 2014. "Ambiguity and Reality," Working Papers on Finance 1418, University of St. Gallen, School of Finance.
  16. Flor, Christian Riis & Hesel, Søren, 2015. "Uncertain dynamics, correlation effects, and robust investment decisions," Journal of Economic Dynamics and Control, Elsevier, vol. 51(C), pages 278-298.
  17. Paul Viefers, 2012. "Should I Stay or Should I Go?: A Laboratory Analysis of Investment Opportunities under Ambiguity," Discussion Papers of DIW Berlin 1228, DIW Berlin, German Institute for Economic Research.
  18. Jianjun Miao, 2004. "A Note on Consumption and Savings under Knightian Uncertainty," Annals of Economics and Finance, Society for AEF, vol. 5(2), pages 299-311, November.

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