Investment, consumption and hedging under incomplete markets

Jianjun Miao and Neng Wang

No 289, 2006 Meeting Papers from Society for Economic Dynamics

Abstract: Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. Motivated by this observation, we extend the standard real options approach to investment to an incomplete markets environment and analyze the joint decisions of business investments, consumption-saving and portfolio selection. We show that precautionary saving motive affects the investment timing decision in an important way. When the investment payoffs are given in lump sum, risk aversion accelerates investment. Moreover, when the agent's precautionary motive is strong enough, an increase in volatility may accelerate investment, opposite to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against his investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. When the investment payoffs are given in flows, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing the reversal of the results in the lump sum payoff case.

Keywords: real options; idiosyncratic risk; precautionary saving; incomplete markets (search for similar items in EconPapers)
JEL-codes: E2 G11 G32 (search for similar items in EconPapers)
Date: 2006
New Economics Papers: this item is included in nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Downloads: (external link)
https://www.red-files-public.s3.amazonaws.com/meetpapers/2006/paper_289.pdf (application/pdf)
Our link check indicates that this URL is bad, the error code is: 404 Not Found

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)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:red:sed006:289

Access Statistics for this paper

More papers in 2006 Meeting Papers from Society for Economic Dynamics Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA. Contact information at EDIRC.
Bibliographic data for series maintained by Christian Zimmermann ().