Investment Timing Under Regime Switching

Abstract

This paper is intended to elaborate regime switching and optimal investment timing in a real option framework. The paper differs from the existing literature in a significant way. In this paper we first consider an irreversible investment timing decision by adding a hidden Markov process to model the state of the economy in continuous time. The cost of the investment is driven the Markov chain. Therefore, the investment cost is either K_1 or K_2 depending on whether the economy is in a low cost or high cost state. K_1 and K_2 can be considered as strike prices of a perpetual American option. This is reasonable as people do observe business cycles of macroeconomic variables that determine the investment costs of the project. By introducing this specific structure of stochastic investment costs, the paper presents a different optimal exercising policy for the firm. It is optimal for the firm to exercise much earlier than otherwise suggested by a standard real option model. Moreover, a range of exercising trigger prices is determined. Of course, the value of the growth option that the firm faces is also higher than the one derived by a conventional real option model. Thus, we show that an optimal timing policy suggested by the conventional real option model might ruin the investment opportunities.

The main contribution of our paper is to overcome the limitations discussed above. We assume, instead, that the investment costs follow a Markov chain with a finite state space, though for convenience of exposition we restrict our analysis to a two state Markov chain. This model confines the uncertainty of the investment cost to a controllable range instead of diffusively moving from zero to infinity. Moreover, by calibrating the parameters in our model, that is the elements in the Q-matrix, it is possible to have our stochastic investment cost return to its equilibrium level in the long run. Hence, our assumption of regime switching investment cost is less misspecified than ones with constant or stochastic costs driven by Brownian motions.

Keywords: Investment Timing, Real Option, Regime Switching

JEL Classification: G31