Irreversible Investment Under Interest Rate Variability: New Results

22 Pages Posted: 31 Jan 2002

See all articles by Luis Hernan Radomiro Alvarez

Luis Hernan Radomiro Alvarez

University of Turku - Turku School of Economics

Erkki Koskela

University of Helsinki - Department of Political and Economic Studies; CESifo (Center for Economic Studies and Ifo Institute); Bank of Finland - Research Department; IZA Institute of Labor Economics

Multiple version iconThere are 2 versions of this paper

Date Written: January 2002

Abstract

The current extensive literature on irreversible investment decisions makes the assumption of a constant interest rate. In this paper we study the impact of interest rate and revenue variability on the decision to carry out an irreversible investment project. Given the generality of the considered valuation problem, we first provide a thorough mathematical characterization of the problem and develop some new results. Contrary to what previous literature has suggested, we establish that interest rate variability may have a profound decelerating or accelerating impact on investment demand depending on whether the current interest rate is below or above the long-run steady state interest rate. Moreover, and importantly, allowing for interest rate uncertainty is shown to decelerate rational investment demand by raising both the required exercise premium of the irreversible investment opportunity and the value of waiting. Finally, we demonstrate that increased revenue volatility strengthens the negative impact of interest rate uncertainty and vice versa.

Keywords: Irreversible Investment, Variable Interest Rates, Free Boundary Problems

JEL Classification: Q23, G31, C61

Suggested Citation

Radomiro Alvarez E., Luis Hernan and Koskela, Erkki, Irreversible Investment Under Interest Rate Variability: New Results (January 2002). CESifo Working Paper Series No. 640. Available at SSRN: https://ssrn.com/abstract=298170

Luis Hernan Radomiro Alvarez E.

University of Turku - Turku School of Economics ( email )

Rehtorinpellonkat 3
FIN-20500 Turku
Finland

Erkki Koskela (Contact Author)

University of Helsinki - Department of Political and Economic Studies ( email )

P.O. Box 54
FIN-00014 Helsinki
Finland
+358 9 191 8894 (Phone)
+358 9 191 8877 (Fax)

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Bank of Finland - Research Department ( email )

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FIN-00101 Helsinki
Finland

IZA Institute of Labor Economics

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Germany

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