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Incorporating Risk Preferences Into Real Options Models

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  • Isik, Murat

Abstract

This paper develops a framework to link the expected utility analysis to real options models in order to capture the joint effects of risk aversion and irreversibility associated with real investments. It aims at modifying the theory of investment under uncertainty by incorporating decision makers' risk preferences and allows explicitly analyzing the impacts of risk aversion, uncertainty and irreversibility on decisions such as investment and resource allocations. It addresses the shortcomings of the commonly used expected utility and investment under uncertainty models be generalizing the theory of irreversible investment under uncertainty by allowing for risk-averse investors. We found that uncertainty, irreversibility and risk aversion are important determinants of the optimal timing of irreversible decisions. Ignoring risk preferences in real options models would lead to over or underestimation of magnitude of investments.

Suggested Citation

  • Isik, Murat, 2004. "Incorporating Risk Preferences Into Real Options Models," 2004 Annual meeting, August 1-4, Denver, CO 20027, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
    • Handle: RePEc:ags:aaea04:20027
    DOI: 10.22004/ag.econ.20027
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    References listed on IDEAS

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    1. Pindyck, Robert S, 1988. "Irreversible Investment, Capacity Choice, and the Value of the Firm," American Economic Review, American Economic Association, vol. 78(5), pages 969-985, December.
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    Keywords

    Risk and Uncertainty;

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