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Uncertain dynamics, correlation effects, and robust investment decisions

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  • Flor, Christian Riis
  • Hesel, Søren

Abstract

We analyze a firm׳s investment problem when the dynamics of project value and investment cost are uncertain. We provide an explicit solution using a robust method for an ambiguity averse firm taking this into account. Ambiguity aversion regarding a common risk factor impacts differently than ambiguity aversion regarding investment cost residual risk. Correlation between project value and investment cost matters; ambiguity aversion regarding common risk can decrease the investment probability only if correlation is positive. Ambiguity aversion regarding residual risk always increases the investment probability. When only project value is risky, volatility can monotonically decrease the investment threshold; this does not hold with the multiple prior method.

Suggested Citation

  • Flor, Christian Riis & Hesel, Søren, 2015. "Uncertain dynamics, correlation effects, and robust investment decisions," Journal of Economic Dynamics and Control, Elsevier, vol. 51(C), pages 278-298.
    • Handle: RePEc:eee:dyncon:v:51:y:2015:i:c:p:278-298
    DOI: 10.1016/j.jedc.2014.10.011
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    More about this item

    Keywords

    Real options; Ambiguity; Risk/uncertainty effects; Correlation effects; Investment timing;
    All these keywords.

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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