Irreversible investments and ambiguity aversion

Journal article

Real option valuation has traditionally been concerned with investment under project value uncertainty while assuming that the agent has perfect confidence in a specific model. However, agents do not generally have perfect confidence in their model and this ambiguity may affect their decisions. In addition, the value of real investments is not typically fully spanned by tradable assets because markets are incomplete as is typically the case in energy and commodities. In this paper, we account for the agent’s aversion to model ambiguity and address market incompleteness through the notion of robust indifference prices. We derive analytical results for the perpetual option to invest and the linear complementarity problem that the finite-time version of this problem satisfies. Ambiguity aversion has a number of effects on decision making some of which cannot be explained by altering the agent’s risk aversion. For example, ambiguity averse agents are found to exercise real options both earlier and later than their ambiguity neutral counterparts, depending on whether ambiguity stems from uncertainty in the dynamics of the project value or the dynamics of a hedging asset.

Authors: Cartea, Á; Jaimungal, S

• Publication status: Published
• Peer review status: Peer reviewed
• Publisher: World Scientific Publishing
• Journal: International Journal of Theoretical and Applied Finance
• Volume: 20
• Issue: 7
• Pages: 1750044
• Publication date: 2017-09-18
• Acceptance date: 2017-07-20
• DOI: 10.1142/S0219024917500443
• EISSN: 1793-6322
• ISSN: 0219-0249
• Keywords: Indifference Pricing; Real Options; Robust Optimal Control; Ambiguity Aversion; Risk Aversion