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Risk, uncertainty,and option exercise

Author

Listed:
  • 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.

Suggested Citation

  • Jianjun Miao & Neng Wang, 2010. "Risk, uncertainty,and option exercise," Boston University - Department of Economics - Working Papers Series WP2010-029, Boston University - Department of Economics.
  • Handle: RePEc:bos:wpaper:wp2010-029
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    More about this item

    Keywords

    Ambiguity; Multiple-priors utility; Real options; Optimal stopping problem;

    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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