Risk Aversion, Price Uncertainty, and Irreversible Investments

CentER Discussion Paper No. 2003-119

20 Pages Posted: 17 Jun 2004

See all articles by Rob W. J. van den Goorbergh

Rob W. J. van den Goorbergh

Tilburg University - Department of Finance

Kuno Huisman

Tilburg University, CentER; ASML

Peter M. Kort

Tilburg University - Department of Econometrics & Operations Research; Tilburg University - Center for Economic Research (CentER)

Date Written: 2003

Abstract

This paper generalizes the theory of irreversible investment under uncertainty by allowing for risk averse investors in the absence of complete markets. Until now, this theory has only been developed in the cases of risk neutrality or risk aversion in combination with complete markets. Within a general setting, we prove the existence of a unique critical output price that distinguishes price regions in which it is optimal for a risk averse investor to invest and price regions in which one should refrain from investing. We use a class of utility functions that exhibit non-increasing absolute risk aversion to examine the effects of risk aversion, price uncertainty, and other parameters on the optimal investment decision. We find that risk aversion reduces investment, particularly if the investment size is large. Moreover, we find that a rise in price uncertainty increases the value of deferring irreversible investments. This effect is stronger for high levels of risk aversion. In addition, we provide, for the first time, closed-form comparative statics formulas for the risk neutral investor.

Keywords: Investments under uncertainty, real options, risk averse investor, incomplete markets

JEL Classification: C61, D81, G31

Suggested Citation

van den Goorbergh, Rob W. J. and Huisman, Kuno J.M. and Kort, Peter, Risk Aversion, Price Uncertainty, and Irreversible Investments (2003). CentER Discussion Paper No. 2003-119, Available at SSRN: https://ssrn.com/abstract=556955 or http://dx.doi.org/10.2139/ssrn.556955

Rob W. J. Van den Goorbergh (Contact Author)

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 8222 (Phone)

Kuno J.M. Huisman

Tilburg University, CentER ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

ASML ( email )

De Run 6501
Veldhoven, 5504 DR
Netherlands

Peter Kort

Tilburg University - Department of Econometrics & Operations Research ( email )

Tilburg, 5000 LE
Netherlands
+31 13 466 2062 (Phone)
+31 13 466 3072 (Fax)

HOME PAGE: http://center.uvt.nl/staff/kort/

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2062 (Phone)
+31 13 466 3072 (Fax)

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