Real options with overextrapolation

Kebin Deng, Jiaxin Peng, Juan Peng and Yuhua Zhang

Economic Modelling, 2022, vol. 114, issue C

Abstract: This study incorporates the overextrapolation belief into the classic real options model. Using the stochastic dynamic programming method, we obtain the semiclosed-form solutions for the optimal investment and valuation of real options and the welfare loss owing to overextrapolation. The theoretical results show that overextrapolation has significant effects on the investment and pricing, which depend on the belief that overextrapolation induces the agent to underinvest in and undervalue the option with low belief concerning the anticipated return. Conversely, overextrapolation leads to overinvestment and overvaluation for agents with high belief. Moreover, our model predicts that welfare loss owing to distorted investment due to overextrapolation is inessential.

Keywords: Real option; Overextrapolation; Investment; Welfare loss (search for similar items in EconPapers)
JEL-codes: C13 G11 G12 G31 (search for similar items in EconPapers)
Date: 2022
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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:114:y:2022:i:c:s0264999322001614

DOI: 10.1016/j.econmod.2022.105915

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