Real Options With Unknown-Date Events

Northwestern University CMS-EMS Working Paper No. 1378

33 Pages Posted: 10 Feb 2004

See all articles by Oscar Gutiérrez Arnáiz

Oscar Gutiérrez Arnáiz

University of Zaragoza

Francisco Ruiz-Aliseda

Pontifical Catholic University of Chile

Date Written: November 2006

Abstract

The real options literature has provided new insights on how to manage irreversible capital investments whose payoffs are always uncertain. Two of the most important predictions from such theory are: (i) greater risk delays a firm's investment timing, and (ii) greater risk increases the option value of waiting. This paper challenges such conclusions in a setting in which the relevant random variable is the arrival time of an unfavorable event. Another contribution of the paper is to introduce a novel framework in which a firm updates its beliefs about the profitability of an investment opportunity by simply waiting to invest. Thus, a wait-and-see approach allows the firm to capitalize on favorable market evolutions and avoid adverse ones to some extent. Our framework is simple and does not require using stochastic calculus, which allows for an economic interpretation of optimal investment policies for the cases of one-time and sequential investments.

Keywords: Investment under Uncertainty, Option Value, Simple and Compound Options, Bad News Principle, Hazard Rate, Bayesian Updating

JEL Classification: D81, G31, L12

Suggested Citation

Gutiérrez Arnáiz, Oscar and Ruiz-Aliseda, Francisco, Real Options With Unknown-Date Events (November 2006). Northwestern University CMS-EMS Working Paper No. 1378. Available at SSRN: https://ssrn.com/abstract=965862 or http://dx.doi.org/10.2139/ssrn.965862

Oscar Gutiérrez Arnáiz

University of Zaragoza ( email )

Economics of Business
Gran Via 2
50005 Zaragoza
Spain
+34976761803 (Phone)

Francisco Ruiz-Aliseda (Contact Author)

Pontifical Catholic University of Chile ( email )

Vicuna Mackenna 4860
Santiago, 99999
Chile

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