Incorporating decision makers' risk preferences into real options models

Murat Isik

Applied Economics Letters, 2005, vol. 12, issue 12, 729-734

Abstract: This study develops a framework to link the expected utility analysis to real options models in order to capture the joint effects of risk aversion and irreversibility. It aims at modifying the theory of investment under uncertainty by incorporating decision makers' risk preferences and allows explicitly analysing the impacts of risk aversion, uncertainty and irreversibility on decisions such as investment and resource allocations. It addresses the shortcomings of the commonly used expected utility and investment under uncertainty models by generalizing the theory of irreversible investment to allow for risk-averse investors. It was found that uncertainty, irreversibility and risk aversion are important determinants of the optimal timing of irreversible decisions. Ignoring risk preferences in real options models would lead to overestimation or underestimation of the magnitude of investments.

Date: 2005
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DOI: 10.1080/13504850500192523

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