Investment, Hedging, and Consumption Smoothing

47 Pages Posted: 19 Jul 2004

See all articles by Jianjun Miao

Jianjun Miao

Boston University - Department of Economics

Neng Wang

Columbia University - Columbia Business School, Finance; National Bureau of Economic Research (NBER); Asian Bureau of Finance and Economic Research (ABFER)

Date Written: July 2004

Abstract

This paper analyzes a risk averse entrepreneur's real investment decision under incomplete markets. The entrepreneur smoothes his intertemporal consumption by investing in both a risk-free asset and a risky asset, which allows him to partially hedge against the project cash flow risk. We show that risk aversion lowers both the project value upon investment and the option value of waiting to invest through the precautionary saving effect. Furthermore, risk aversion delays investment since the project value is reduced more than the option value to invest. It is also shown that although hedging can reduce the cash flow risk, it may have a positive or negative return effect, depending on the correlation between the cash flow risk and the market. Consequently, investment timing is not monotonic with the extent of hedging opportunity. Finally, welfare implications of hedging are analyzed.

Keywords: Real options, risk aversion, incomplete markets, hedging, precautionary saving

JEL Classification: G11, G31, E2

Suggested Citation

Miao, Jianjun and Wang, Neng, Investment, Hedging, and Consumption Smoothing (July 2004). Available at SSRN: https://ssrn.com/abstract=565601 or http://dx.doi.org/10.2139/ssrn.565601

Jianjun Miao (Contact Author)

Boston University - Department of Economics ( email )

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HOME PAGE: http://people.bu.edu/miaoj

Neng Wang

Columbia University - Columbia Business School, Finance ( email )

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