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Irreversible Investments and Ambiguity Aversion

Álvaro Cartea

University of Oxford; University of Oxford - Oxford-Man Institute of Quantitative Finance

Sebastian Jaimungal

University of Toronto - Department of Statistics

November 18, 2011

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.

Number of Pages in PDF File: 26

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

JEL Classification: D81, G31, G11

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Date posted: November 20, 2011 ; Last revised: May 1, 2015

Suggested Citation

Cartea, Álvaro and Jaimungal, Sebastian, Irreversible Investments and Ambiguity Aversion (November 18, 2011). Available at SSRN: https://ssrn.com/abstract=1961786 or http://dx.doi.org/10.2139/ssrn.1961786

Contact Information

Álvaro Cartea
University of Oxford ( email )
Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom
University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )
Eagle House
Walton Well Road
Oxford, Oxfordshire OX2 6ED
United Kingdom
Sebastian Jaimungal (Contact Author)
University of Toronto - Department of Statistics ( email )
100 St. George St.
Toronto, Ontario M5S 3G3
HOME PAGE: http://www.utstat.utoronto.ca/sjaimung
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