Real Options, Ambiguity, and Dynamic Consistency - A Technical Note

Abstract

Recent research on real options does not only consider optimal investment decisions under risk, but also under ambiguity. However, most models that allow for ambiguity are generally not dynamically consistent. Examples are, among others, the $\alpha$-MEU model, the imprecision aversion model, or the NMEU model. Dynamic consistency is however required to solve optimal stopping real options problems analytically or in closed-form. This paper highlights the resulting difficulties, which are often overlooked, exemplarily for the NMEU model.

Keywords: Ambiguity, dynamic consistency, real options, NMEU preferences, rectangularity, optimal stopping

JEL Classification: D81, G11