Risk, Uncertainty, and Option Exercise
Columbia Business School - Finance and Economics
Boston University - Department of Economics
Many economic decisions can be described as an option exercise or optimal stopping problem under uncertainty. Motivated by experimental evidence such as the Ellsberg Paradox, we follow Knight (1921) and distinguish risk from uncertainty. To afford this distinction, we adopt the multiple-priors utility model. We show that the impact of ambiguity on the option exercise decision depends on the relative degrees of ambiguity about continuation payoffs and termination payoffs. Consequently, ambiguity may accelerate or delay option exercise. We apply our results to firm investment and exit problems, and show that the myopic NPV rule can be optimal for an agent having an extremely high degree of ambiguity aversion.
Number of Pages in PDF File: 36
Keywords: Ambiguity, multiple-priors utility, real options, optimal stopping problem
JEL Classification: D81, G31working papers series
Date posted: October 15, 2004
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