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Investment, Hedging, and Consumption Smoothing

Author

Listed:
  • Jianjun Miao

    (Boston University)

  • Neng Wang

    (Columbia University)

Abstract

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.

Suggested Citation

  • Jianjun Miao & Neng Wang, 2004. "Investment, Hedging, and Consumption Smoothing," Finance 0407014, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpfi:0407014
    Note: Type of Document - pdf; pages: 46
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    File URL: https://econwpa.ub.uni-muenchen.de/econ-wp/fin/papers/0407/0407014.pdf
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    References listed on IDEAS

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    Cited by:

    1. David Hobson & Yeqi Zhu, 2014. "Multi-asset consumption-investment problems with infinite transaction costs," Papers 1409.8037, arXiv.org.
    2. Vicky Henderson & David Hobson, 2013. "Risk Aversion, Indivisible Timing Options, and Gambling," Operations Research, INFORMS, vol. 61(1), pages 126-137, February.

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