An Equilibrium Model of Investment Under Uncertainty
Haas School of Business Working Paper, 2002
57 Pages Posted: 21 Jan 2003
There are 2 versions of this paper
An Equilibrium Model of Investment Under Uncertainty
An Equilibrium Model of Investment under Uncertainty
Date Written: November 13, 2002
Abstract
In standard real options models the determination of one agent's optimal investment strategy is made without consideration of other agents' strategies. While this sort of partial equilibrium analysis may be appropriate when studying most financial derivatives, it is not appropriate when analyzing real options. In real world markets competition almost always plays an important role in the profitability of any investment decision and should not be ignored. In this paper we determine, as part of a strategic equilibrium, the optimal real option exercise strategy of heterogeneous agents facing increasing costs-to-scale of developing capacity. We also calculate option values explicitly. Accounting for the impact of other agents' investment decisions has several implications. In equilibrium, agents optimally delay investment longer than the standard real options approach prescribes. Increasing capacity, resulting endogenously from the agents' optimal exercise of options, attenuates price growth, resulting in negatively skewed prices. The asymmetric downside risk induces agents to exercise options later than they would in a fixed capacity economy with the same average rate of long-term price growth. Furthermore, we find no erosion in option value: consideration of strategic interactions does not mitigate the fraction of a project's value that may be attributed to the right to future development. Finally, this paper presents a preference based general equilibrium model in which we observe deviations from the zero NPV rule as predicted by real option theory.
Keywords: Real Options, General Equilibrium, Asset Pricing, Real Estate, Development
JEL Classification: G12, D51, C68
Suggested Citation: Suggested Citation
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