Irreversible Investments and Ambiguity Aversion

Abstract:     
Real-option valuation traditionally is concerned with investment under conditions of project-value uncertainty, while assuming that the agent has perfect confidence in a specific model. However, agents generally do not have perfect confidence in their models, and this ambiguity affects their decisions. Moreover, real investments are not spanned by tradable assets and generate inherently incomplete markets. In this work, we account for an agent's aversion to model ambiguity and address market incompleteness through the notation of robust indifference prices. We derive analytical results for the perpetual option to invest and the linear complementarity problem that the finite time problem satisfies. We find that ambiguity aversion has dual effects that are similar to, but distinct from, those of risk aversion. In particular, agents are found to exercise options earlier or later than their ambiguity-neutral counterparts, depending on whether the ambiguity stems from uncertainty in the investment or in a hedging asset.

Number of Pages in PDF File: 36

Keywords: Real Options, Ambiguity Aversion, Risk Aversion, Robust Optimal Control, Indifference Pricing

JEL Classification: D81, G31, G11

working papers series