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Risk, Uncertainty, and Option Exercise

Journal of Economic Dynamics & Control, Vol. 35, pp. 442-461, 2004

30 Pages Posted: 26 Oct 2011  

Neng Wang

Columbia Business School - Finance and Economics

Jianjun Miao

Boston University - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: January 7, 2004

Abstract

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 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.

Suggested Citation

Wang, Neng and Miao, Jianjun, Risk, Uncertainty, and Option Exercise (January 7, 2004). Journal of Economic Dynamics & Control, Vol. 35, pp. 442-461, 2004 . Available at SSRN: https://ssrn.com/abstract=1949388

Neng Wang (Contact Author)

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Jianjun Miao

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
United States
617-353-6675 (Phone)

HOME PAGE: http://people.bu.edu/miaoj

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