Real Options and Risk Aversion
21 Pages Posted: 17 Jul 2003 Last revised: 28 Sep 2008
Date Written: September 1, 2007
In the standard real options approach to investment under uncertainty, agents formulate optimal policies under the assumptions of risk neutrality or complete financial markets. Although these assumptions are crucial to the implications of the approach, they are not particularly relevant to most real-world environments where agents face incomplete markets and are exposed to undiversifiable risks. In this paper we extend the real options approach to incorporate risk aversion for a general class of utility functions. We show that risk aversion provides an incentive for the investor to delay investment and leads to a significant erosion in project values.
Keywords: Risk aversion, Real options, Investment timing
JEL Classification: G31, E22
Suggested Citation: Suggested Citation