Real options with illiquidity of exercise opportunities

Michi Nishihara ()
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Michi Nishihara: Graduate School of Economics, Osaka University

No 19-01, Discussion Papers in Economics and Business from Osaka University, Graduate School of Economics

Abstract: This paper presents a framework to study real options with illiquidity of option exercise opportunities. I incorporate a constraint that the investment time is chosen from Poisson arrival times in the standard real option value (ROV) model. I derive the closed-form solution and show that illiquidity decreases the option value of waiting and the investment threshold. I extend the results to a case with different types of projects and show that an inferior project can be undertaken in the presence of illiquidity. I prove that the solution of the illiquid model converges to that of the ROV model for higher liquidity and converges to that of the net present value (NPV) model for lower liquidity. I also show that the solution agrees with the limit of the corresponding regime-switching model. The results fill the gaps in the NPV, ROV, and regime-switching models and reveal the effects of illiquidity on investment decisions.

Keywords: real option; net present value; regime switching; liquidity; search theory (search for similar items in EconPapers)
JEL-codes: D82 G13 G33 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2019-03
New Economics Papers: this item is included in nep-cfn and nep-ppm
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