Ambiguous Volatility, Asymmetric Information and Irreversible Investment

Abstract

We develop a signal game model of investment to examine the implications of ambiguity aversion on corporate equilibrium strategies, investment dynamics, and financing decisions within incomplete markets marked by asymmetric information. Our analysis reveals that volatility ambiguity aversion exerts a comparable yet more pronounced influence than asymmetric information, leading to heightened financing costs, decreased investment probabilities and prompting corporates to adopt non-participation investment decisions. Notably, volatility ambiguity aversion exhibits an amplifier effect, magnifying financing costs, adverse selection costs, and distortion in investment choices under asymmetric information. This heightened ambiguity aversion escalates the likelihood of inefficient separating and pooling equilibria, ultimately resulting in a discernible welfare loss. The findings underscore the substantial impact of ambiguity aversion on strategic decision-making and equilibrium outcomes in the context of investment within environments characterized by information asymmetry and incomplete markets.

Keywords: Ambiguity aversion, Asymmetric information, Equity-for-Guarantee Swap, Signal game, Irreversible investment