Irreversible Investments and Ambiguity Aversion

Abstract

Real option valuation has traditionally been concerned with investment under project value uncertainty while assuming the agent has perfect confidence in a specific model. However, agents do not generally have perfect confidence in their model and this {\it ambiguity} affects their decisions. Moreover, real investments are not typically fully spanned by tradable assets--hence markets are inherently incomplete. In this work, we account for the agent's aversion to model ambiguity and address market incompleteness through the notation of {\it robust indifference prices}. We derive analytical results for the perpetual option to invest and the linear complementarity problem that the finite time problem satisfies. Ambiguity aversion is found to have dual effects that are similar, but distinct from risk aversion. Agent's are found to exercise options both earlier and later than their ambiguity neutral counterparts, depending on whether ambiguity stems from uncertainty in the investment or a hedging asset.

Keywords: Real Options, Ambiguity Aversion, Risk Aversion, Robust Optimal Control, Indifference Pricing

JEL Classification: D81, G31, G11