English, Article, Journal or magazine article edition: Investment, consumption and hedging under incomplete markets Junjian Miao; Jianjun Miao; Neng Wang

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Bookmark: http://trove.nla.gov.au/version/30059
Physical Description
  • preprint
Language
  • English

Edition details

Title
  • Investment, Consumption, and Hedging under Incomplete Markets
Author
  • Junjian Miao
  • Jianjun Miao
  • Neng Wang
Physical Description
  • preprint
Notes
  • Entrepreneurs often face undiversi¯able idiosyncratic risks from their business invest- ments. Motivated by this observation, we extend the standard real options approach to investment to an incomplete markets environment and analyze the joint decisions of busi- ness investments, consumption-saving and portfolio selection. Our analysis depends cru- cially on whether the investment payo®s are in lump-sum or in °ows. Precautionary saving e®ect plays a key role. In the lump-sum payo® case, risk aversion accelerates investment. Moreover, when the agent's precautionary motive is strong enough, an increase in volatility accelerates investment. These results may be reversed for the °ow payo® case. Finally, hedging a®ects investment decisions by changing the expected growth of wealth and reduc- ing the agent's exposure to idiosyncratic risk. The agent's hedging demand is higher when he is closer to exercising the investment option.
  • real options, idiosyncratic risk, hedging, risk aversion, precautionary saving,incomplete markets
  • RePEc:bos:macppr:wp2005-011
  • Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. Motivated by this observation, we extend the standard real options approach to investment to an incomplete markets environment and analyze the joint decisions of business investments, consumption-saving and portfolio selection. We show that precautionary saving motive affects the investment timing decision in an important way. When the investment payoffs are given in lump sum, risk aversion accelerates investment. Moreover, when the agent's precautionary motive is strong enough, an increase in volatility may accelerate investment, opposite to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against his investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. When the investment payoffs are given in flows, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing the reversal of the results in the lump sum payoff case.
  • RePEc:red:sed006:289
  • Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. We extend the standard real options approach to an incomplete markets environment and analyze the joint decisions of business investments, consumption/​savings, and portfolio selection. For a lump-sum investment payoff and an agent with a sufficiently strong precautionary savings motive, an increase in volatility can accelerate investment, contrary to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. Finally, when the investment payoff is a series of flows, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing a reversal of the results in the lump-sum payoff case.
  • RePEc:nbr:nberwo:13250
Language
  • English
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