Valuing investment projects under interest rate risk: empirical evidence from European firms

Luca Vincenzo Ballestra, Graziella Pacelli and Davide Radi ()

Applied Economics, 2017, vol. 49, issue 56, 5662-5672

Abstract: In this article, we perform an empirical investigation of the effect of the interest rate uncertainty on the valuation of investment projects. The analysis is carried out by employing a real option approach and by considering a set of firms that operate in various production sectors in the euro area. In particular, the revenues generated by the investment projects are modelled using a geometric Brownian motion, whereas the interest rate is specified as a stochastic process of Vasicek type. Moreover, using the volatility of the equity return as a proxy, the volatility of the revenues is calibrated to real firm data, while the parameters of the interest rate model are estimated by fitting the Euribor time series. To this aim, an ad hoc calibration procedure is developed which is based on the maximum likelihood principle and thus has the merit of being simple, fast and suitable for practical purposes. Our study reveals that the interest rate uncertainty reduces the valuation of investment projects. However, stochastic interest rates do not provide a substantial improvement with respect to constant interest rates, or at least the differences are not statistically significant.

Date: 2017
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DOI: 10.1080/00036846.2017.1327120

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