Investment, consumption, and hedging under incomplete markets
By: Jianjun Miao, Neng Wang.
Contributors: Wang, Neng.; National Bureau of Economic Research.
Series: NBER working paper series -- working paper 13250.; Working paper series (National Bureau of Economic Research) -- working paper no. 13250.
Publisher: National Bureau of Economic Research
Published: 2007
Place of publication: Cambridge, Mass
Language: eng
Number of pages: 45
Subjects: Investments; Risk; Portfolio management; Real options (Finance); Consumption (Economics); Hedging (Finance)
Description: 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.
Notes: "July 2007."

Includes bibliographical references (p. 38-41).

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