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Investment under Uncertainty and Incomplete Markets

Author

Listed:
  • Julien Hugonnier

    (HEC, University of Lausanne and FAME)

  • Erwan Morellec

    (Simon School of Business, University of Rochester)

Abstract

In the standard real options approach to investment under uncertainty, agents formulate optimal policies under the assumptions of risk neutrality or perfect capital markets. However in most situations, corporate executives face incomplete markets either because they receive compensation packages that restrict their portfolios or because cash flows from the firm's investment opportunities are not spanned by those of existing assets. The present paper examines the impact of managerial risk aversion on investment decisions when the manager is exposed to idiosyncratic risk. In the paper, the investment policy selected by the manager reflects a trade-off between his incentives to reduce risk and the need to ensure sufficient efficiency to prevent control challenges. The analysis demonstrates that risk aversion induces the manager to speed up investment, leading to a significant erosion of the value of the option to wait and to investment near the zero net present value threshold.

Suggested Citation

  • Julien Hugonnier & Erwan Morellec, 2004. "Investment under Uncertainty and Incomplete Markets," FAME Research Paper Series rp122, International Center for Financial Asset Management and Engineering.
    • Handle: RePEc:fam:rpseri:rp122
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    File URL: http://www.swissfinanceinstitute.ch/rp122.pdf
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    Citations

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    Cited by:

    1. M. R Grasselli, 2006. "Getting real with real options," Papers math/0604302, arXiv.org.
    2. Jianjun Miao & Neng Wang, 2004. "Investment, Hedging, and Consumption Smoothing," Finance 0407014, University Library of Munich, Germany.
    3. Jacco Thijssen, 2010. "Irreversible investment and discounting: an arbitrage pricing approach," Annals of Finance, Springer, vol. 6(3), pages 295-315, July.

    More about this item

    Keywords

    Incomplete markets; Risk aversion; Real options;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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