Testing the Option Value Theory of Irreversible Investment

Tarek Harchaoui and Pierre Lasserre

No 9905, Cahiers de recherche du Département des sciences économiques, UQAM from Université du Québec à Montréal, Département des sciences économiques

Abstract: This paper statistically tests the option theory of irreversible investment under uncertainty. Using contingent claims valuation, we derive the value of options to invest in capacity, where the projects are endogenous to the economic circumstances prevailing at the investment date. We then test whether capacity investment decisions made by Canadian copper mines are compatible with the trigger price implied by the theory. The results speak strongly in favor of option theory as a theory of real investment. Our model explains both investment size and timing satisfactorily, from a statistical, and from an economic, point of view, and numerical simulations with a mean-reverting process suggest that the results do not depend crucially on the price being assumed to follow a geometric Brownian motion.

Nous etablissons par la methode des actifs contingents la valeur de l'option d'effectuer des investissements irréversibles réels qui sont sensibles aux paramètres économiques prévalant au moment de la décision. Nous testons ensuite si des mines de cuivre canadiennes choisissent bien d'effectuer leurs investissements en capacité de production au moment où le prix du cuivre atteint le niveau critique impliqué par la théorie. Les résultats sont fortement en faveur de celle-ci. Le modèle explique tant la taille que la date des investissements, d'une manière statistiquement et économiquement satisfaisantes; des simulations avec un processus de retour à la moyenne indiquent que ces résultats ne dépendent pas de façon cruciale de l'hypothèse que le prix suit un processus brownien géométrique.

Keywords: Irreversible Investment; Uncertainty; Contingent Claims; Option Value; Putty Clay; Real Investment; Trigger Price - Investissement irréversible; incertitude; actifs contingents; valeur d'option; investissement réel; prix critique (search for similar items in EconPapers)
JEL-codes: D92 G1 L72 Q31 (search for similar items in EconPapers)
Pages: 29
Date: 1999-05
New Economics Papers: this item is included in nep-agr, nep-cfn, nep-env, nep-fin and nep-ind
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Published in the International Economic Review, Vol 42, No 1, February 2001, p. 141-166

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Related works:
Journal Article: Testing the Option Value Theory of Irreversible Investment (2001)
Working Paper: Testing the Option Value Theory of Irreversible Investment (1999)
Working Paper: Testing the Option Value Theory of Irreversible Investment (1995)
Working Paper: Testing the Option Vakue Theory of Irreversible Investment (1995)
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