Optimal risk adoption: a real options approach

Abstract

This study develops a real options approach for analyzing the optimal risk adoption policy in an environment where the adoption means a switch from one stochastic flow representation into another. We establish that increased volatility does not necessarily decelerate investment, as predicted by the standard literature on real options, once the underlying volatility of the state variable is made endogenous. We prove that for a decision maker with a convex (concave) objective function, increased post-adoption volatility increases (decreases) the expected cumulative present value of the post-adoption profit flow, which consequently decreases (increases) the option value of waiting and, therefore, accelerates (decelerates) current investment. Copyright Springer-Verlag Berlin/Heidelberg 2003Risk adoption, Investment, Real option.,

Optimal regime switching under risk aversion and uncertainty

“…In order to enter the new market regime, the decisionmaker must abandon the A C C E P T E D M A N U S C R I P T existing one. Consequently, this approach enables a comparison with models that either do not allow for operational flexibility (Alvarez & Stenbacka, 2004) or may allow for suspension and resumption options, yet assume symmetric regimes (Chronopoulos et al, 2011). We find that if market regimes are asymmetric, then greater price uncertainty and risk aversion may induce earlier abandonment of a mature technology.…”

“…More pertinent to our analysis is the framework of Alvarez & Stenbacka (2004), who implement attitudes towards risk via a hyperbolic absolute risk aversion (HARA) utility function and develop an analytical framework for regime-switching under price uncertainty. More specifically, they consider the problem of optimal switching from one stochastic cash flow representation to another, which, contrary to Alvarez & Stenbacka (2001), implies a structural change in the project's cash flows in terms of a change in volatility while keeping the drift constant.…”

“…Also, we let τ and τ (2) 0 , respectively, while the corresponding optimal price thresholds are denoted by p…”

“…However, if the embedded option to invest in the third regime is not available, then these expressions can be obtained analytically. Indeed, in the absence of the option to invest in the third regime, the value of the option to abandon the second one is denoted by F (2) 0 (P ) and is indicated in (11).…”

“…Notice that the embedded option to switch to the third regime raises the incentive to abandon the second one, and, as a result, p (2) 0 > p (2) 0 . This happens because at p…”