Irreversible Investment in Stochastically Cyclical Markets
51 Pages Posted: 10 Mar 2007
Date Written: March 6, 2007
This paper presents a new framework for studying irreversible (dis)investment when a market follows a random number of random-length cycles (such as a high-tech product market). It is assumed that a firm facing such market evolution is always unsure about whether the current cycle is the last one, although it can update its beliefs about the probability of facing a permanent decline by observing that no further growth phase arrives. We show that the existence of regime shifts in fluctuating markets suffices for an option value of waiting to (dis)invest to arise, and we provide a marginal interpretation of the optimal (dis)investment policies, absent in the real options literature. The paper also shows that, despite the stochastic process of the underlying variable has a continuous sample path, the discreteness in the regime changes implies that the sample path of the firm's value experiences jumps whenever the regime switches all of a sudden, irrespective of whether the firm is active or not.
Keywords: Real Options, Regime-Switching, Bad News Principle, Signal Extraction Problem, Entry and Exit, Industry Life Cycles.
JEL Classification: D92, G31, L12
Suggested Citation: Suggested Citation