Irreversible investment, ambiguity and equity default swaps

ABSTRACT

We study the impact of ambiguity on the pricing and timing of the option to invest. There is a funding gap to undertake the investment, which is covered by entering into an equity-for-guarantee swap. Our model predicts that the more ambiguity-averse the agents, the less the option value, the later the investment and the higher the guarantee cost and the leverage. If the entrepreneur is more ambiguity-averse than the insurer, the investment threshold slightly rises as the perceived ambiguity increases, and on the contrary, if the entrepreneur is less ambiguity-averse than the insurer, the investment threshold increases sharply as the perceived ambiguity rises.

KEYWORDS:

• Real options
• equity default swaps
• ambiguity

JEL CLASSIFICATION:

• G12
• G24

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ The uncertainty which is reducible to a single probability measure with known parameters is referred to as . That is, the firm may face Knightian uncertainty in contemplating its investment, facing not a single probability measure but a set of probability measures.

² The Choquet–Brownian motion is a distorted Wiener process, where the distortion derives from the nature and intensity of preferences towards ambiguity. It was shown to be the continuous time limit of a specific kind of random walk, the Choquet Random Walk (CRW). A CRW may be described as a binomial lattice (Bernoulli model) with equal capacities (instead of additive probabilities) on the two states at each node.

³ is the probability of investment and defined as , see Hackbarth and Mauer (2012). In addition, for concreteness, we naturally assume the guarantee cost is defined by using the insurer’s ambiguity aversion.

Additional information

Funding

The research for this article was supported by National Natural Science Foundation of China (Project Nos. 71371068 and 71171078).