Irreversible Investment Under Interest Rate Variability: New Results

Bank of Finland Discussion Paper No. 29/2003

32 Pages Posted: 19 Feb 2004

See all articles by Luis Hernan Radomiro Alvarez

Luis Hernan Radomiro Alvarez

University of Turku - Turku School of Economics

Erkki Koskela

University of Helsinki - Department of Political and Economic Studies; CESifo (Center for Economic Studies and Ifo Institute); Bank of Finland - Research Department; IZA Institute of Labor Economics

Multiple version iconThere are 2 versions of this paper

Date Written: November 12, 2003

Abstract

The current literature on irreversible investment decisions usually makes the assumption of a constant interest rate. We study the impact of interest rate and revenue variability on the decision to carry out an irreversible investment project. Given the generality of the valuation problem considered, we first provide a thorough mathematical characterization of the two-dimensional optimal stopping problem and develop some new results. We establish that interest rate variability has a profound decelerating or accelerating impact on investment demand depending on whether the current interest rate is below or above the long run steady state interest rate, and that its quantitative size may be very large. Allowing for interest rate uncertainty is shown to decelerate rational investment demand by raising both the required exercise premium of the irreversible investment opportunity and the value of waiting. Finally, we demonstrate that increased revenue volatility strengthens the negative impact of interest rate uncertainty and vice versa.

Keywords: irreversible investment, variable interest rates, free boundary

JEL Classification: Q23, G31, C61

Suggested Citation

Radomiro Alvarez E., Luis Hernan and Koskela, Erkki, Irreversible Investment Under Interest Rate Variability: New Results (November 12, 2003). Bank of Finland Discussion Paper No. 29/2003. Available at SSRN: https://ssrn.com/abstract=501764 or http://dx.doi.org/10.2139/ssrn.501764

Luis Hernan Radomiro Alvarez E. (Contact Author)

University of Turku - Turku School of Economics ( email )

Rehtorinpellonkat 3
FIN-20500 Turku
Finland

Erkki Koskela

University of Helsinki - Department of Political and Economic Studies ( email )

P.O. Box 54
FIN-00014 Helsinki
Finland
+358 9 191 8894 (Phone)
+358 9 191 8877 (Fax)

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Bank of Finland - Research Department ( email )

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FIN-00101 Helsinki
Finland

IZA Institute of Labor Economics

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Germany

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