The Curious Incident of the Investment in the Market: Real Options and a Fair Gamble

43 Pages Posted: 24 Mar 2005  

Jonathan D. Evans

University of Bath

Vicky Henderson

University of Warwick; University of Oxford - Oxford Man Institute

David G. Hobson

University of Bath - School of Mathematical Sciences

Date Written: March 2005

Abstract

Is there any point to which you would wish to draw my attention? To the curious incident of the investment in the market. The agent did nothing in the market. That was the curious incident. (with apologies to Sir Arthur Conan-Doyle.)

In this paper we study an optimal timing problem for the sale of a non-traded real asset. We solve this problem for a risk-averse manager under two scenarios: firstly when the manager has access to no other investment opportunities, and secondly when he may also invest in a continuously traded financial asset. We construct the model such that the financial asset has zero risk premium and thus represents a fair gamble, and such that it is uncorrelated with the real asset, so that it is not useful for hedging. In the absence of the real asset, the manager would not include the financial asset in his optimal portfolio.

Although the problem is designed such that naive intuition would imply that the optimal strategy is the same irrespective of whether the manager is allowed to invest in the financial asset or not, curiously we find that for certain parameter values this is not the case. Access to the fair gamble improves the manager's expected utility in some situations, and reduces the probability that the real asset is ever sold. Our work has implications for modeling of portfolio choice problems since seemingly extraneous assets can impact on optimal behavior.

Keywords: Real assets, Perpetual options, Optimal stopping, Incomplete markets, Portfolio choice, Real options, Portfolio constraints

JEL Classification: G11, G12, G31

Suggested Citation

Evans, Jonathan D. and Henderson, Vicky and Hobson, David G., The Curious Incident of the Investment in the Market: Real Options and a Fair Gamble (March 2005). AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=686110 or http://dx.doi.org/10.2139/ssrn.686110

Jonathan D. Evans

University of Bath ( email )

Claverton Down
Bath, BA2 7AY
United Kingdom

Vicky Henderson (Contact Author)

University of Warwick ( email )

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

University of Oxford - Oxford Man Institute ( email )

Eagle House
Walton Well Road
Oxford, Oxfordshire OX2 6ED
United Kingdom
44 01865 616600 (Phone)

David G. Hobson

University of Bath - School of Mathematical Sciences ( email )

Bath, BA2 7AY
United Kingdom

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