Risk Aversion, Price Uncertainty and Irreversible Investments

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

Research output: Working paperDiscussion paperOther research output

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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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Risk aversion
Price uncertainty
Irreversible investment
Investors
Risk-averse
Investing
Investment decision
Complete markets
Investment under uncertainty
Optimal investment
Utility function
Comparative statics
Absolute risk aversion
Risk neutrality

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). Tilburg: Finance.
van den Goorbergh, R.W.J. ; Huisman, K.J.M. ; Kort, P.M. / Risk Aversion, Price Uncertainty and Irreversible Investments. Tilburg : Finance, 2003. (CentER Discussion Paper).
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van den Goorbergh, RWJ, Huisman, KJM & Kort, PM 2003 'Risk Aversion, Price Uncertainty and Irreversible Investments' CentER Discussion Paper, vol. 2003-119, Finance, Tilburg.

Risk Aversion, Price Uncertainty and Irreversible Investments. / van den Goorbergh, R.W.J.; Huisman, K.J.M.; Kort, P.M.

Tilburg : Finance, 2003. (CentER Discussion Paper; Vol. 2003-119).

Research output: Working paperDiscussion paperOther research output

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N2 - 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.

AB - 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.

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KW - prices

KW - uncertainty

KW - investment

KW - options

KW - incomplete markets

M3 - Discussion paper

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BT - Risk Aversion, Price Uncertainty and Irreversible Investments

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van den Goorbergh RWJ, Huisman KJM, Kort PM. Risk Aversion, Price Uncertainty and Irreversible Investments. Tilburg: Finance. 2003. (CentER Discussion Paper).