Optimal investment under operational flexibility, risk aversion, and uncertainty

Traditional real options analysis addresses the problem of investment under uncertainty assuming a risk-neutral decision maker and complete markets. In reality, however, decision makers are often risk averse and markets are incomplete. We confirm that risk aversion lowers the probability of investme...

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Bibliographic Details
Published in:European journal of operational research 2011-08, Vol.213 (1), p.221-237
Main Authors: Chronopoulos, Michail, De Reyck, Bert, Siddiqui, Afzal
Format: Article
Language:English
Subjects:
Applied sciences
Decision analysis
Decision analysis Investment under uncertainty Real options Operational flexibility Risk aversion
Decision making
Decision theory. Utility theory
Exact sciences and technology
Financing
Flexibility
Investment
Investment policy
Investment under uncertainty
Markets
Operational flexibility
Operational research and scientific management
Operational research. Management science
Operations research
Optimization
Portfolio theory
Real options
Real options analysis
Risk
Risk aversion
Risk theory. Actuarial science
Studies
Uncertainty
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Summary:Traditional real options analysis addresses the problem of investment under uncertainty assuming a risk-neutral decision maker and complete markets. In reality, however, decision makers are often risk averse and markets are incomplete. We confirm that risk aversion lowers the probability of investment and demonstrate how this effect can be mitigated by incorporating operational flexibility in the form of embedded suspension and resumption options. Although such options facilitate investment, we find that the likelihood of investing is still lower compared to the risk-neutral case. Risk aversion also increases the likelihood that the project will be abandoned, although this effect is less pronounced. Finally, we illustrate the impact of risk aversion on the optimal suspension and resumption thresholds and the interaction among risk aversion, volatility, and optimal decision thresholds under complete operational flexibility.
ISSN:0377-2217
1872-6860
1872-6860
DOI:10.1016/j.ejor.2011.03.007