Irreversible Investment in Stochastically Cyclical Markets

51 Pages Posted: 10 Mar 2007

See all articles by Francisco Ruiz-Aliseda

Francisco Ruiz-Aliseda

Pontifical Catholic University of Chile

Jianjun Wu

Compass Lexecon; Princeton Economics Group

Date Written: March 6, 2007

Abstract

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

Ruiz-Aliseda, Francisco and Wu, Jianjun, Irreversible Investment in Stochastically Cyclical Markets (March 6, 2007). Available at SSRN: https://ssrn.com/abstract=968585 or http://dx.doi.org/10.2139/ssrn.968585

Francisco Ruiz-Aliseda (Contact Author)

Pontifical Catholic University of Chile ( email )

Vicuna Mackenna 4860
Santiago, 99999
Chile

Jianjun Wu

Compass Lexecon

707 State Rd
Suite 223
Princeton, NJ 08540
United States

Princeton Economics Group ( email )

707 State Rd
Princeton, NJ 08540
United States

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