INCORPORATING RISK PREFERENCES INTO REAL OPTIONS MODELS

This paper develops a framework to link the expected utility analysis to real options models in order to capture the joint effects of risk aversion and irreversibility associated with real investments. It aims at modifying the theory of investment under uncertainty by incorporating decision makers' risk preferences and allows explicitly analyzing the impacts of risk aversion, uncertainty and irreversibility on decisions such as investment and resource allocations. It addresses the shortcomings of the commonly used expected utility and investment under uncertainty models be generalizing the theory of irreversible investment under uncertainty by allowing for risk-averse investors. We found that uncertainty, irreversibility and risk aversion are important determinants of the optimal timing of irreversible decisions. Ignoring risk preferences in real options models would lead to over or underestimation of magnitude of investments.


Issue Date:
2004
Publication Type:
Conference Paper/ Presentation
PURL Identifier:
http://purl.umn.edu/20027
Total Pages:
18
JEL Codes:
D81; G1
Series Statement:
Selected Paper




 Record created 2017-04-01, last modified 2017-08-24

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