"Risk, Uncertainty, and Option Exercise"
©
Journal of Economic Dynamics & Control,
2011
Volume: 35
|
Pages: 442-461
Publication type: Journal article
Research Archive Topic: Business Economics and Public Policy, Capital Markets and Investments, Corporate Finance, Real Estate, Risk Management
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 afford 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.
The PDF above is a preprint version of the article. The final version may be found at < http://dx.doi.org/10.1016/j.jedc.2010.11.005 >.
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