Fixed Investments and Capital Flows: A Real Options Approach

Abstract

This paper draws a link between international capital flows and the real options approach to investment by extending the development and cascade model applied by Grenadier (Journal of Finance 51, 1996) to real estate markets. This modified model rationalizes such phenomena as gradual investment, investment booms, and investment during recessions, and it emphasizes the role of sunk costs and uncertainty in determining the timing of investment. We also show that the correlation between capital flows and the spread between the domestic return to capital and the foreign interest rate depends importantly on the source of uncertainty: if the foreign interest rate is stochastic, the correlation is expected to be high, but would be low if the uncertainty affects the domestic rate of return.

Keywords: fixed investments, capital flows, real options

JEL Classification: F21, F32, F39