Investment, Consumption, and Hedging under Incomplete Markets

Jianjun Miao and Neng Wang

No 13250, NBER Working Papers from National Bureau of Economic Research, Inc

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 the joint decisions of business investments, consumption/savings, and portfolio selection. For a lump-sum investment payoff and an agent with a sufficiently 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.

JEL-codes: E2 G11 G31 (search for similar items in EconPapers)
Date: 2007-07
New Economics Papers: this item is included in nep-bec, nep-dge, nep-ent, nep-mac and nep-ppm
Note: AP CF EFG
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Citations: View citations in EconPapers (82)

Published as Miao, Jianjun & Wang, Neng, 2007. "Investment, consumption, and hedging under incomplete markets," Journal of Financial Economics, Elsevier, vol. 86(3), pages 608-642, December.

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Journal Article: 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)
Working Paper: Investment, consumption and hedging under incomplete markets (2006)
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