Download This PaperReal Options, Risk Aversion and Markets: A Corporate Finance Perspective
41 Pages Posted: 29 Nov 2018 Last revised: 28 May 2020
Date Written: April 21, 2020
Abstract
We analyze how the presence of financial markets effects the optimal exercise of real options for a risk averse agent. In this process we examine the role of the minimal martingale measure and the Capital Asset Pricing Model (CAPM). Using value-matching and smooth-pasting conditions, we generalize results of Shackleton and Sodal (2005) for the one-dimensional complete market case and extend their framework to a multi-dimensional incomplete market setup, identifying the minimal martingale measure as the appropriate reference measure, consistent with the CAPM.
We provide a characterization of the optimal exercise rule in terms of the capital market line. Our approach allows us to unambiguously characterize the effect of systematic risk on the speed of exercise of the option, but we also show that the effect of idiosyncratic risk can contravene conventional belief.
Finally we demonstrate in form of numerical examples that it is indeed crucial to correctly account for the presence of financial markets and its interplay with risk aversion when exercising real options, as otherwise large financial losses can occur.
Keywords: Finance, Real Options, Risk Aversion, CAPM, Optimal Stopping
JEL Classification: G11, G31, C61, D81
Suggested Citation: Suggested Citation