Abstract
The real options literature has provided new insights on how to manage irreversible capital investments whose payoffs are 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. In particular, we model situations in which a firm must choose the time at which to invest in a project whose profit grows at a known rate until a random date is reached and decays thereafter, which may be representative of stochastic product or industry life cycles. This is a novel framework in which a firm can update 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.
Similar content being viewed by others
References
Arozamena L., Cantillon E.: Investment incentives in procuremen auctions. Rev Econ Stud 71, 1–18 (2004)
Barbarino A.T., Jovanovic B.: Shakeouts and market crashes. Int Econ Rev 48, 385–420 (2007)
Bernanke B.S.: Irreversibility, uncertainty and cyclical investment. Q J Econ 98, 85–106 (1983)
Bollen N.P.B.: Real options and product life cycles. Manag Sci 45, 670–684 (1999)
Bowman E.H., Moskowitz G.T.: Real options analysis and strategic decision making. Org Sci 12, 772–777 (2001)
Boyarchenko S., Levendorskiĭ S.: American options: the EPV pricing model. Ann Finance 1, 267–292 (2005)
Diamond P.A., Stiglitz J.E.: Increases in risk and in risk aversion. J Econ Theory 8, 337–360 (1974)
Dixit A.K., Pindyck R.S.: Investment Under Uncertainty. Princeton University Press, Princeton (1994)
Ferderer J.P.: The impact of uncertainty on aggregate investment spending: an empirical analysis. J Money Credit Bank 25, 30–48 (1993)
Guiso L., Parigi G.: Investment and demand uncertainty. Q J Econ 114, 185–227 (1999)
Gutiérrez O.: Devaluating projects and the investment-uncertainty relationship. J Econ Dyn Control 31, 3881–3888 (2007)
Gutiérrez O., Ruiz-Aliseda F.: Entry patterns over the product life cycle. Manch School 77, 594–610 (2009)
Leahy J.V., Whited T.M.: The effect of uncertainty on investment: some stylized facts. J Money Credit Bank 28, 64–83 (1996)
Majd S., Pindyck R.S.: Time to build, option value, and investment decisions. J Financ Econ 18, 7–27 (1987)
McDonald R.L., Siegel D.: The value of waiting to invest. Q J Econ 101, 707–727 (1986)
Roberts K., Weitzman M.L.: Funding criteria for research, development and exploration projects. Econometrica 49, 1261–1288 (1981)
Ruiz-Aliseda, F.: Entry and exit in duopoly under uncertainty. Mimeo, Universitat Pompeu Fabra (2008)
Ruiz-Aliseda, F., Wu, J.: Irreversible investment in stochastically cyclical markets. Mimeo, Universitat Pompeu Fabra (2008)
Sarkar S.: On the investment-uncertainty relationship in a real options model. J Econ Dyn Control 24, 219–225 (2000)
Weeds H.: Strategic delay in a real options model of R&D competition. Rev Econ Stud 69, 729–747 (2002)
Wong K.: The effect of uncertainty on investment timing in a real options model. J Econ Dyn Control 31, 2152–2167 (2006)
Author information
Authors and Affiliations
Corresponding author
Rights and permissions
About this article
Cite this article
Gutiérrez, O., Ruiz-Aliseda, F. Real options with unknown-date events. Ann Finance 7, 171–198 (2011). https://doi.org/10.1007/s10436-010-0153-7
Received:
Accepted:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s10436-010-0153-7