Valuing the Option to Invest in an Incomplete Market

35 Pages Posted: 27 Jul 2004

Date Written: November 2006

Abstract

This paper considers the impact of entrepreneurial risk aversion and incompleteness on investment timing and the value of the option to invest. A risk averse entrepreneur faces the irreversible decision of when to pay a cost in order to receive a one-off investment payoff. The uncertainty associated with the investment payoff can be partly offset by hedging, but the remaining unhedgeable risk is idiosyncratic. Nested within our incomplete set-up is the complete model of McDonald and Siegel (1986) which assumes investment payoffs are perfectly spanned by traded assets. We find risk aversion and idiosyncratic risk erode option value and lower the investment threshold. Our main finding is that there is a parameter region within which the complete and incomplete models give differing investment signals. In this region, the option is never exercised (and investment never occurs) in the complete model, whereas the entrepreneur exercises the option in the incomplete setting. Strikingly, this parameter region corresponds to a negative implicit dividend yield on the payoff, and so this exercise behavior contrasts with conventional wisdom of Merton (1973) for complete markets. Finally, in this parameter region, increased volatility speeds-up investment and option values are not strictly convex in project value, in sharp contrast to the conclusion of standard real options models.

Keywords: Real options, risk-aversion, non-traded assets, investment under uncertainty, incomplete markets

JEL Classification: G11, G12, G31

Suggested Citation

Henderson, Vicky, Valuing the Option to Invest in an Incomplete Market (November 2006). Available at SSRN: https://ssrn.com/abstract=569865 or http://dx.doi.org/10.2139/ssrn.569865

Vicky Henderson (Contact Author)

University of Warwick ( email )

Gibbet Hill Rd.
Coventry, West Midlands CV4 8UW
United Kingdom
44 (0)2476 574811 (Phone)

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