Uncertain Dynamics, Correlation Effects, and Robust Investment Decisions

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Abstract

We analyze a firm's investment problem when the dynamics of project value and investment cost are uncertain. We provide an explicit solution using a robust method for an ambiguity averse firm taking this into account. Ambiguity aversion regarding a common risk factor impacts differently than ambiguity aversion regarding investment cost residual risk. Correlation between project value and investment cost matters; ambiguity aversion regarding common risk can decrease the investment probability only if correlation is positive. Ambiguity
aversion regarding residual risk always increases the investment probability. When only project value is risky, volatility can monotonically decrease the investment threshold; this does not hold with the multiple prior method.
Translated title of the contributionUncertain Dynamics, Correlation Effects, and Robust Investment Decisions: Uncertain Dynamics, Correlation Effects, and Robust Investment Decisions
Original languageEnglish
JournalJournal of Economic Dynamics and Control
Volume51
Pages (from-to)278-298
ISSN0165-1889
DOIs
Publication statusPublished - 1. Feb 2015

Keywords

  • Ambiguity
  • Correlation effects
  • Investment timing
  • Real options
  • Risk/uncertainty effects

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