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Investment, Hedging, and Consumption Smoothing

  • Jianjun Miao

    (Boston University)

  • Neng Wang

    (Columbia University)

This paper analyzes a risk averse entrepreneur's real investment decision under incomplete markets. The entrepreneur smoothes his intertemporal consumption by investing in both a risk-free asset and a risky asset, which allows him to partially hedge against the project cash flow risk. We show that risk aversion lowers both the project value upon investment and the option value of waiting to invest through the precautionary saving effect. Furthermore, risk aversion delays investment since the project value is reduced more than the option value to invest. It is also shown that although hedging can reduce the cash flow risk, it may have a positive or negative return effect, depending on the correlation between the cash flow risk and the market. Consequently, investment timing is not monotonic with the extent of hedging opportunity. Finally, welfare implications of hedging are analyzed.

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Paper provided by EconWPA in its series Finance with number 0407014.

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Length: 46 pages
Date of creation: 19 Jul 2004
Date of revision:
Handle: RePEc:wpa:wuwpfi:0407014
Note: Type of Document - pdf; pages: 46
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