Investment, Consumption, and Hedging under Incomplete Markets

Jianjun Miao and Neng Wang

No 459, CEMA Working Papers from China Economics and Management Academy, Central University of Finance and Economics

Abstract: Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. We extend the standard real options approach to an incomplete markets environment and analyze their joint decisions of business investments, consumption/savings, and portfolio selection. For a lump-sum investment payoff and an agent with a su¡Àciently strong precautionary savings motive, an increase in volatility can accelerate investment, contrary to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. Finally, when the investment payoff is a series of flows, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing a reversal of the results in the lump-sum payoff case.

Keywords: real options; idiosyncratic risk; hedging; risk aversion; precautionary savings; incomplete markets (search for similar items in EconPapers)
JEL-codes: E2 G11 G31 (search for similar items in EconPapers)
Pages: 46 pages
Date: 2006-09
New Economics Papers: this item is included in nep-bec and nep-cta
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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

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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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