Investment, Consumption, and Hedging Under Incomplete Markets

47 Pages Posted: 13 Jul 2007 Last revised: 16 Sep 2022

See all articles by Neng Wang

Neng Wang

Columbia University - Columbia Business School, Finance; National Bureau of Economic Research (NBER); Asian Bureau of Finance and Economic Research (ABFER)

Jianjun Miao

Boston University - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: July 2007

Abstract

Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. We extend the standard real options approach to an incomplete markets environment and analyze the joint decisions of business investments, consumption/savings, and portfolio selection. For a lump-sum investment payoff and an agent with a sufficiently strong precautionary savings motive, an increase in volatility can accelerate investment, contrary to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. Finally, when the investment payoff is a series of flows, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing a reversal of the results in the lump-sum payoff case.

Suggested Citation

Wang, Neng and Miao, Jianjun, Investment, Consumption, and Hedging Under Incomplete Markets (July 2007). NBER Working Paper No. w13250, Available at SSRN: https://ssrn.com/abstract=1000354

Neng Wang

Columbia University - Columbia Business School, Finance ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Asian Bureau of Finance and Economic Research (ABFER) ( email )

BIZ 2 Storey 4 04-05
1 Business Link
Singapore, 117592
Singapore

Jianjun Miao (Contact Author)

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
United States
617-353-6675 (Phone)

HOME PAGE: http://people.bu.edu/miaoj

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
71
Abstract Views
3,703
Rank
159,344
PlumX Metrics