Investment, Consumption and Hedging under Incomplete Markets

Jianjun Miao and Neng Wang

No WP2005-011, Boston University - Department of Economics - Macroeconomics Working Papers Series from Boston University - Department of Economics

Abstract: Entrepreneurs often face undiversi¯able idiosyncratic risks from their business invest- ments. Motivated by this observation, we extend the standard real options approach to investment to an incomplete markets environment and analyze the joint decisions of busi- ness investments, consumption-saving and portfolio selection. Our analysis depends cru- cially on whether the investment payo®s are in lump-sum or in °ows. Precautionary saving e®ect plays a key role. In the lump-sum payo® case, risk aversion accelerates investment. Moreover, when the agent's precautionary motive is strong enough, an increase in volatility accelerates investment. These results may be reversed for the °ow payo® case. Finally, hedging a®ects investment decisions by changing the expected growth of wealth and reduc- ing the agent's exposure to idiosyncratic risk. The agent's hedging demand is higher when he is closer to exercising the investment option.

Keywords: real options; idiosyncratic risk; hedging; risk aversion; precautionary saving; incomplete markets (search for similar items in EconPapers)
JEL-codes: E2 G11 G31 (search for similar items in EconPapers)
Pages: 42 pages
Date: 2005-10, Revised 2006-09
New Economics Papers: this item is included in nep-bec, nep-fin, nep-fmk and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

Published, Journal of Financial Economics 86 (2007), 608-642

Downloads: (external link)
http://people.bu.edu/miaoj/MiaoWangJFE.pdf (application/pdf)

Related works:
Journal Article: Investment, consumption, and hedging under incomplete markets (2007)
Working Paper: Investment, Consumption, and Hedging under Incomplete Markets (2007)
Working Paper: Investment, Consumption, and Hedging under Incomplete Markets (2006)
Working Paper: Investment, consumption and hedging under incomplete markets (2006)
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