Investment, Hedging, and Consumption Smoothing

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