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Learning, pricing, timing and hedging of the option to invest for perpetual cash flows with idiosyncratic risk

Song, Dandan, Wang, Huamao, Yang, Zhaojun (2014) Learning, pricing, timing and hedging of the option to invest for perpetual cash flows with idiosyncratic risk. Journal of Mathematical Economics (ABS 3), 51 . 1-11 (lead article). ISSN 0304-4068.

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Abstract

The paper considers the option of an investor to invest in a project that generates perpetual cash flows, of which the drift parameter is unobservable. The investor invests in a liquid financial market to partially hedge cash flow risk and estimation risk. We derive two 3-dimensional non-linear free-boundary PDEs satisfied by the utility-based prices of the option and the cash flows. We provide an approach to measure the information value. A numerical procedure is developed. We show that investors have not only idiosyncratic-risk-induced but also estimation-risk-induced precautionary saving demands. A growth of estimation risk, risk aversion or project risk delays investment, but it is accelerated if the project is more closely correlated with the market. Partial information results in a considerable loss, which reaches the peak value at the exercising time and increases with project risk and estimation risk. The more risk-averse the investor or the weaker the correlation, the larger the loss.

Item Type: Article
Uncontrolled keywords: Partial information, Hedging, Real options, Precautionary savings, Information value, Non-linear PDEs
Subjects: H Social Sciences > HB Economic Theory
H Social Sciences > HG Finance
Divisions: Faculties > Sciences > School of Mathematics Statistics and Actuarial Science
Faculties > Social Sciences > Kent Business School > Accounting and Finance
Depositing User: Huamao Wang
Date Deposited: 25 Feb 2014 21:30 UTC
Last Modified: 29 May 2019 11:54 UTC
Resource URI: https://kar.kent.ac.uk/id/eprint/38469 (The current URI for this page, for reference purposes)
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