Incorporating decision makers’ risk preferences into real options models

Abstract

This study develops a framework to link the expected utility analysis to real options models in order to capture the joint effects of risk aversion and irreversibility. It aims at modifying the theory of investment under uncertainty by incorporating decision makers’ risk preferences and allows explicitly analysing the impacts of risk aversion, uncertainty and irreversibility on decisions such as investment and resource allocations. It addresses the shortcomings of the commonly used expected utility and investment under uncertainty models by generalizing the theory of irreversible investment to allow for risk-averse investors. It was found that uncertainty, irreversibility and risk aversion are important determinants of the optimal timing of irreversible decisions. Ignoring risk preferences in real options models would lead to overestimation or underestimation of the magnitude of investments.

Notes

¹ The capital assets pricing model is usually used to determine the risk-adjusted rate of return as: , where r is the risk free interest rate, δ _pm is the correlation between the asset and the market, π is the market price or risk and σ is the variability of returns of the asset.

² Real world investment decisions are much more complex than the case considered here. To focus on the impact of risk preferences on irreversible investment decisions, several simplifying assumptions are made in the model.

³ It is possible to consider a more realistic scenario in which the investment decision is partially irreversible. In that case, the impact of uncertainty and irreversibility would be less than the case of complete irreversibility.