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Irreversible Investment under Interest Rate Variability: New Results

Author

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  • Luis H. R. Alvarez
  • Erkki Koskela

Abstract

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.

Suggested Citation

  • Luis H. R. Alvarez & Erkki Koskela, 2002. "Irreversible Investment under Interest Rate Variability: New Results," CESifo Working Paper Series 640, CESifo Group Munich.
  • Handle: RePEc:ces:ceswps:_640
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    References listed on IDEAS

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    More about this item

    Keywords

    irreversible investment; variable interest rates; free boundary problems.;

    JEL classification:

    • Q23 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Renewable Resources and Conservation - - - Forestry
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • J15 - Labor and Demographic Economics - - Demographic Economics - - - Economics of Minorities, Races, Indigenous Peoples, and Immigrants; Non-labor Discrimination

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