Much of the work on investment under uncertainty assumes that the project's value follows Geometric Brownian Motion (GBM) with constant volatility. I use a more general assumption for the project-value process. I use the so-called Constant-Elasticity-of-Variance (CEV) diffusion model where the volatility is a non-increasing function of the project's value. I show that, if the CEV volatility structure holds, the firm that uses the standard GBM assumption is exposed to significant errors when making the optimal investment decision. In particular, the GBM assumption often yields suboptimal postponement of investment and undervalues the option of waiting to invest under deteriorated business conditions.

Investment under higher uncertainty when business conditions worsen

SBUELZ, Alessandro
2005-01-01

Abstract

Much of the work on investment under uncertainty assumes that the project's value follows Geometric Brownian Motion (GBM) with constant volatility. I use a more general assumption for the project-value process. I use the so-called Constant-Elasticity-of-Variance (CEV) diffusion model where the volatility is a non-increasing function of the project's value. I show that, if the CEV volatility structure holds, the firm that uses the standard GBM assumption is exposed to significant errors when making the optimal investment decision. In particular, the GBM assumption often yields suboptimal postponement of investment and undervalues the option of waiting to invest under deteriorated business conditions.
JEL-Classification: G12; G13; G31. Investment under uncertainty; Real options; Diffusion processes; CEV
File in questo prodotto:
Non ci sono file associati a questo prodotto.

I documenti in IRIS sono protetti da copyright e tutti i diritti sono riservati, salvo diversa indicazione.

Utilizza questo identificativo per citare o creare un link a questo documento: https://hdl.handle.net/11562/304514
Citazioni
  • ???jsp.display-item.citation.pmc??? ND
  • Scopus ND
  • ???jsp.display-item.citation.isi??? ND
social impact