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Risk, uncertainty,and option exercise

Listed author(s):
  • 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)

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
Handle: RePEc:bos:wpaper:wp2010-029
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