Risk Aversion, Price Uncertainty and Irreversible Investments

R.W.J. van den Goorbergh, K.J.M. Huisman, P.M. Kort

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Abstract

This paper generalizes the theory of irreversible investment under uncertainty by allowing for risk averse investors in the absence of com-plete markets.Until now this theory has only been developed in the cases of risk neutrality, or risk aversion in combination with complete markets.Within a general setting, we prove the existence of a unique critical output price that distinguishes price regions in which it is optimal for a risk averse investor to invest and price regions in which one should refrain from investing.We use a class of utility functions that exhibit non-increasing absolute risk aversion to examine the e ects of risk aversion, price uncertainty, and other parameters on the optimal investment decision.We nd that risk aversion reduces investment, particularly if the investment size is large.Moreover, we nd that a rise in price uncertainty increases the value of deferring irreversible investments.This e ect is stronger for high levels of risk aversion.In addition, we provide, for the rst time, closed-form comparative statics formulas for the risk neutral investor.
Original languageEnglish
Place of PublicationTilburg
PublisherFinance
Number of pages20
Volume2003-119
Publication statusPublished - 2003

Publication series

NameCentER Discussion Paper
Volume2003-119

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Keywords

  • risk
  • prices
  • uncertainty
  • investment
  • options
  • incomplete markets

Cite this

van den Goorbergh, R. W. J., Huisman, K. J. M., & Kort, P. M. (2003). Risk Aversion, Price Uncertainty and Irreversible Investments. (CentER Discussion Paper; Vol. 2003-119). Finance.