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How to analyze the investment–uncertainty relationship in real option models?

By Diderik Lund

Abstract

The real options tradition originally predicted a decreasing relationship between uncertainty and investment, through the positive effect of higher uncertainty on the trigger level for revenue relative to costs. An opposing effect on the probability of reaching the level has been identified, yielding a total effect with ambiguous sign. This paper makes three points. The “opposing” effect is not always opposing. Systematic risk cannot generally be assumed to increase with volatility. A probability is not the best measure of investment. The sign of the total effect is again ambiguous. This ambiguity is illustrated, depending on specification of model and parameters.investment; uncertainty; real options; stochastic control

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