Real Options under Choquet-Brownian Ambiguitys

Abstract

Real options models characterized by the presence of “ambiguity” (or “Knightian uncertainty”) have been recently proposed. But based on recursive multiple-priors preferences, they typically describe ambiguity through a range of Geometric Brownian motions and solve it by application of a maxmin expected utility criterion among them (worst case). This reduces acceptable individual preferences to the single case of an extreme form of pessimism. In contrast, by relying on dynamically consistent “Choquet-Brownian” motions to represent the ambiguous cash flows expected from a project, we show that a much broader spectrum of attitudes towards ambiguity may be accounted for, improving the explanatory and application potentials of these appealing expanded real options models. In the case of a perpetual real option to invest, ambiguity aversion may delay the moment of exercise of the option, while the opposite holds true for an ambiguity seeking decision maker. Furthermore, an intricate relationship between risk and ambiguity appears strikingly in our model.