Learning, Pricing, Timing and Hedging of the Option to Invest for Perpetual Cash Flows with Idiosyncratic Risk

Abstract

The paper considers the option of an investor to invest in a project that generates perpetual cash flows, of which the drift parameter is unobservable. The investor invests in a liquid financial market to partially hedge cash flow risk and estimation risk. We derive two 3-dimensional non-linear free-boundary PDEs satisfied by the utility-based prices of the option and the cash flows. We provide an approach to measure the information value. A numerical procedure is developed. We show that investors have not only idiosyncratic-risk-induced but also estimation-risk-induced precautionary saving demands. A growth of estimation risk, risk aversion or project risk delays investment, but it is accelerated if the project is more closely correlated with the market. Partial information results in a considerable loss, which reaches the peak value at the exercising time and increases with project risk and estimation risk. The more risk-averse the investor or the weaker the correlation, the larger the loss.

Keywords: Partial information, Hedging, Real options, Precautionary savings, Information value, Non-linear PDEs

JEL Classification: C61, G11, G31