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A Bayesian Approach to Real Options: The Case of Distinguishing between Temporary and Permanent Shocks

70 Pages Posted: 6 Mar 2008 Last revised: 21 Nov 2010

Steven R. Grenadier

Stanford Graduate School of Business

Andrey Malenko

MIT Sloan School of Management

Date Written: April 28, 2010

Abstract

Traditional real options models demonstrate the importance of the "option to wait" due to uncertainty over future shocks to project cash flows. However, there is often another important source of uncertainty: uncertainty over the permanence of past shocks. Adding Bayesian uncertainty over the permanence of past shocks augments the traditional option to wait with an additional "option to learn." The implied investment behavior differs significantly from that in standard models. For example, investment may occur at a time of stable or decreasing cash flows, respond sluggishly to cash flow shocks, and depend on the timing of project cash flows.

Keywords: irreversible investment, real options, Bayesian updating, learning, temporary and permanent shocks, mean reversion

JEL Classification: D81, D83, G13, G31

Suggested Citation

Grenadier, Steven R. and Malenko, Andrey, A Bayesian Approach to Real Options: The Case of Distinguishing between Temporary and Permanent Shocks (April 28, 2010). Journal of Finance, Vol. 65, No. 5, pp. 1949-1986; AFA 2009 San Francisco Meetings Paper; EFA 2008 Athens Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1102673

Steven R. Grenadier (Contact Author)

Stanford Graduate School of Business ( email )

Graduate School of Business
Stanford, CA 94305-5015
United States
650-725-0706 (Phone)
650-725-6152 (Fax)

Andrey Malenko

MIT Sloan School of Management ( email )

100 Main Street
E62-619
Cambridge, MA 02142
United States
617-225-9301 (Phone)

HOME PAGE: http://www.mit.edu/~amalenko

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