Real Options With Unknown-Date Events
Northwestern University CMS-EMS Working Paper No. 1378
33 Pages Posted: 10 Feb 2004
Date Written: November 2006
Abstract
The real options literature has provided new insights on how to manage irreversible capital investments whose payoffs are always uncertain. Two of the most important predictions from such theory are: (i) greater risk delays a firm's investment timing, and (ii) greater risk increases the option value of waiting. This paper challenges such conclusions in a setting in which the relevant random variable is the arrival time of an unfavorable event. Another contribution of the paper is to introduce a novel framework in which a firm updates its beliefs about the profitability of an investment opportunity by simply waiting to invest. Thus, a wait-and-see approach allows the firm to capitalize on favorable market evolutions and avoid adverse ones to some extent. Our framework is simple and does not require using stochastic calculus, which allows for an economic interpretation of optimal investment policies for the cases of one-time and sequential investments.
Keywords: Investment under Uncertainty, Option Value, Simple and Compound Options, Bad News Principle, Hazard Rate, Bayesian Updating
JEL Classification: D81, G31, L12
Suggested Citation: Suggested Citation
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