Investment,consumption, and hedging under incomplete markets |
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Authors: | Jianjun Miao Neng Wang |
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Institution: | 1. Department of Economics, Boston University, 270 Bay State Road, Boston, MA 02215, USA;2. Department of Finance, The Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong;3. Columbia Business School, 3022 Broadway, Uris Hall 812, New York, NY 10027, USA and National Bureau of Economic Research |
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Abstract: | 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. |
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Keywords: | G11 G31 E2 |
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