Risk, uncertainty, and option exercise |
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Authors: | Jianjun Miao Neng Wang |
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Affiliation: | a Department of Economics, Boston University, CEMA, Central University of Finance and Economics, 270 Bay State Road, Boston, MA 02215, United States b Xinhua School of Finance and Insurance, Zhongnan University of Economics and Law, China c Columbia Business School, NBER, 3022 Broadway, Uris Hall 812, New York, NY 10027, United States d Shanghai University of Finance and Economics, China |
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Abstract: | Many economic decisions can be described as an option exercise or optimal stopping problem under uncertainty. Motivated by experimental evidence such as the Ellsberg Paradox, we follow Knight (1921) and distinguish risk from uncertainty. To capture this distinction, we adopt the multiple-priors utility model. We show that the impact of ambiguity on the option exercise decision depends on the relative degrees of ambiguity about continuation payoffs and termination payoffs. Consequently, ambiguity may accelerate or delay option exercise. We apply our results to investment and exit problems, and show that the myopic NPV rule can be optimal for an agent having an extremely high degree of ambiguity aversion. |
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Keywords: | Ambiguity Multiple-priors utility Real options Optimal stopping problem |
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