Firm Decisions under Jump-Diffusive Dynamics

Working Paper No. HEIDWP04-2019

35 Pages Posted: 19 Apr 2019 Last revised: 25 Feb 2020

See all articles by Neha Deopa

Neha Deopa

Graduate Institute of International and Development Studies

Daniele Rinaldo

Graduate Institute of International and Development Studies

Date Written: March 21, 2019

Abstract

We present a model of firm investment under uncertainty and partial irreversibility in which uncertainty is represented by a jump diffusion. This allows to represent both the continuous Gaussian volatility and the discontinuous uncertainty related to information arrival, sudden changes and large shocks. The model shows how both sources of uncertainty negatively impact the optimal investment and disinvestment policies, and how the presence of large negative jumps can drastically affect the firm’s ability to recover. Our results show that the standard Gaussian framework consistently underestimates the negative effect of uncertainty on firm investment decisions. We test these predictions on a panel dataset of UK firms: we first structurally estimate the uncertainty parameters using multinomial maximum likelihood and differential evolution techniques and subsequently study their impact on firm investment rates, validating our model predictions.

Keywords: firm investment, uncertainty, jump diffusions, partial irreversibility, real options

JEL Classification: C61, C62, D21, D22, D8

Suggested Citation

Deopa, Neha and Rinaldo, Daniele, Firm Decisions under Jump-Diffusive Dynamics (March 21, 2019). Working Paper No. HEIDWP04-2019, Available at SSRN: https://ssrn.com/abstract=3357701 or http://dx.doi.org/10.2139/ssrn.3357701

Neha Deopa (Contact Author)

Graduate Institute of International and Development Studies ( email )

Chemin Eugène-Rigot 2A
Case postale 1672
Geneva, 1211
Switzerland

Daniele Rinaldo

Graduate Institute of International and Development Studies ( email )

Chemin Eugène-Rigot 2A
Case postale 1672
Geneva, 1211
Switzerland

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