Working Paper: NBER ID: w13250
Authors: Jianjun Miao; Neng Wang
Abstract: Entrepreneurs often face undiversifiable idiosyncratic risks from their business investments. We extend the standard real options approach to an incomplete markets environment and analyze the joint decisions of business investments, consumption/savings, and portfolio selection. For a lump-sum investment payoff and an agent with a sufficiently strong precautionary savings motive, an increase in volatility can accelerate investment, contrary to the standard real options analysis. When the agent can trade the market portfolio to partially hedge against investment risk, the systematic volatility is compensated via the standard CAPM argument, and the idiosyncratic volatility generates a private equity premium. Finally, when the investment payoff is a series of flows, the agent's idiosyncratic risk exposure alters both the implied option value and the implied project value, causing a reversal of the results in the lump-sum payoff case.
Keywords: Investment; Consumption; Hedging; Incomplete Markets; Entrepreneurship
JEL Codes: E2; G11; G31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| idiosyncratic volatility (G19) | earlier investment decisions (G11) |
| precautionary savings motive (D14) | earlier investment decisions (G11) |
| idiosyncratic risk (D81) | lower certainty equivalent wealth (D81) |
| lower certainty equivalent wealth (D81) | earlier investment decisions (G11) |
| partial hedging against project risk (G13) | diminished precautionary savings demand (E21) |
| diminished precautionary savings demand (E21) | earlier investment decisions (G11) |
| risk aversion (D81) | investment timing (G11) |