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Investment, consumption and hedging under incomplete markets

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  • Jianjun Miao
  • Neng Wang

    (Finance and Economics Columbia Business School)

Abstract

Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. Motivated by this observation, we extend the standard real options approach to investment to an incomplete markets environment and analyze the joint decisions of business investments, consumption-saving and portfolio selection. We show that precautionary saving motive affects the investment timing decision in an important way. When the investment payoffs are given in lump sum, risk aversion accelerates investment. Moreover, when the agent's precautionary motive is strong enough, an increase in volatility may accelerate investment, opposite to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against his investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. When the investment payoffs are given in flows, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing the reversal of the results in the lump sum payoff case.

Suggested Citation

  • Jianjun Miao & Neng Wang, 2006. "Investment, consumption and hedging under incomplete markets," 2006 Meeting Papers 289, Society for Economic Dynamics.
    • Handle: RePEc:red:sed006:289
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    More about this item

    Keywords

    real options; idiosyncratic risk; precautionary saving; incomplete markets;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment

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