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Irreversible Investment under Interest Rate Variability: New Results

  • Luis H. R. Alvarez
  • Erkki Koskela

The current extensive literature on irreversible investment decisions makes the assumption of constant interest rate. In this paper we study the impact of interest rate and revenue variability on the decision to carry out an irreversible investment project. Given the generality of the considered valuation problem, we first provide a thorough mathematical characterization of the problem and develop some new results. Contrary to what previous literature has suggested we establish that interest rate variability may have a profound decelerating or accelerating impact on investment demand depending on whether the current interest rate is below or above the long run steady state interest rate. Moreover, and importantly, allowing for interest rate uncertainty is shown to decelerate rational investment demand by raising both the required exercise premium of the irreversible investment opportunity and the value of waiting. Finally, we demonstrate that increased revenue volatility strengthens the negative impact of interest rate uncertainty and vice versa.

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File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2002/wp-cesifo-2002-01/640.PDF
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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 640.

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Date of creation: 2002
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Handle: RePEc:ces:ceswps:_640
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  9. Arrow, Kenneth J & Fisher, Anthony C, 1974. "Environmental Preservation, Uncertainty, and Irreversibility," The Quarterly Journal of Economics, MIT Press, vol. 88(2), pages 312-19, May.
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  19. Nickell, Stephen J, 1974. "On Expectations, Government Policy and the Rate of Investment," Economica, London School of Economics and Political Science, vol. 41(163), pages 241-55, August.
  20. Bertola, Giuseppe, 1998. "Irreversible investment," Research in Economics, Elsevier, vol. 52(1), pages 3-37, March.
  21. Cukierman, Alex, 1980. "The Effects of Uncertainty on Investment under Risk Neutrality with Endogenous Information," Journal of Political Economy, University of Chicago Press, vol. 88(3), pages 462-75, June.
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  25. Yaozhong Hu & Bernt ├śksendal, 1998. "Optimal time to invest when the price processes are geometric Brownian motions," Finance and Stochastics, Springer, vol. 2(3), pages 295-310.
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