Irreversible Investment under Interest Rate Variability: Some Generalizations

Luis H. R. Alvarez and Erkki Koskela
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Luis H. R. Alvarez: Turku School of Economics and Business Administration
Erkki Koskela: University of Helsinki, Bank of Finland, Center for Economic Studies—IFO, and Institute for the Study of Labor

Journal of Business, 2006, vol. 79, issue 2, pages 623-644

Abstract: We study the impact of interest rate and revenue variability on the decision to carry out irreversible investment. We provide a mathematical characterization of the two-dimensional optimal stopping problem and show that interest rate variability has a decelerating or accelerating impact on investment depending on whether the current interest rate is below or above the long-run steady state. Allowing for interest rate volatility decelerates investment by raising both the required exercise premium of the investment opportunity and the value of waiting. Finally, increased revenue volatility is shown to strengthen the negative impact of interest rate volatility and vice versa.

Date: 2006

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