Real options with overextrapolation

Abstract

This study incorporates the overextrapolation belief into the classic real options model. Using the stochastic dynamic programming method, we obtain the semiclosed-form solutions for the optimal investment and valuation of real options and the welfare loss owing to overextrapolation. The theoretical results show that overextrapolation has significant effects on the investment and pricing, which depend on the belief that overextrapolation induces the agent to underinvest in and undervalue the option with low belief concerning the anticipated return. Conversely, overextrapolation leads to overinvestment and overvaluation for agents with high belief. Moreover, our model predicts that welfare loss owing to distorted investment due to overextrapolation is inessential.

Keywords: Real option; Overextrapolation; Investment; Welfare loss

JEL Classification: G31; G11; G12; C13