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Real options with illiquidity of exercise opportunities

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  • Michi Nishihara

    (Graduate School of Economics, Osaka University)

Abstract

This paper presents a framework to study real options with illiquidity of option exercise opportunities. I incorporate a constraint that the investment time is chosen from Poisson arrival times in the standard real option value (ROV) model. I derive the closed-form solution and show that illiquidity decreases the option value of waiting and the investment threshold. I extend the results to a case with different types of projects and show that an inferior project can be undertaken in the presence of illiquidity. I prove that the solution of the illiquid model converges to that of the ROV model for higher liquidity and converges to that of the net present value (NPV) model for lower liquidity. I also show that the solution agrees with the limit of the corresponding regime-switching model. The results fill the gaps in the NPV, ROV, and regime-switching models and reveal the effects of illiquidity on investment decisions.

Suggested Citation

  • Michi Nishihara, 2019. "Real options with illiquidity of exercise opportunities," Discussion Papers in Economics and Business 19-01, Osaka University, Graduate School of Economics.
    • Handle: RePEc:osk:wpaper:1901
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    References listed on IDEAS

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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    real option; net present value; regime switching; liquidity; search theory;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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