Consumption Utility-Based Pricing and Timing of the Option to Invest with Partial Information

Abstract

This paper extends real options theory to consider the situation where the mean appreciation rate of the value of an irreversible investment project is not observable and governed by an Ornstein-Uhlenbeck process. Our main purpose is to analyze the impact of the uncertainty of the mean appreciation rate on the pricing and investment timing of the option to invest under incomplete markets with partial information. We assume that an investor aims to maximize expected discounted utility of lifetime consumption. Based on consumption utility indifference pricing method, stochastic control and filter theory, we obtain under CARA utility the implied values and the optimal investment thresholds of the option to invest, which are determined by a semi-closed-form solution to a free-boundary PDE problem. The solution is independent of the utility time-discount rate. We provide numerical results by finite difference methods and compare the results with those under a fully observable case. Numerical calculations show that partial information leads to a significant loss of the implied value of the option to invest. This loss increases quickly with the uncertainty of the mean appreciation rate. In contrast to standard real options theory, a high volatility of project values might decrease the implied value of the option to invest as well as the implied information value.

Keywords: Partial Information, Consumption Utility-Based Indifference Pricing, Real Options, Implied Information Value

JEL Classification: G11, G31, E2