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Incomplete markets, ambiguity, and irreversible investment

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JournalJournal of Economic Dynamics and Control
DatePublished - Jun 2011
Issue number6
Volume35
Number of pages13
Pages (from-to)909-921
Original languageEnglish

Abstract

The problem of irreversible investment with idiosyncratic risk is studied by interpreting market incompleteness as a source of ambiguity over the appropriate no-arbitrage discount factor. Themaxmin utility overmultiple priors framework is used to model and solve the irreversible investment problem. Multiple priors are modeled using the notion of k-ignorance. This set-up is used to analyze finitely lived options. For infinitely lived options the notion of constant k-ignorance is introduced. For these sets of density generators the corresponding optimal stopping problem is solved for general (in-)finite horizon optimal stopping problems driven by geometric Brownian motion. It is argued that an increase in the set of priors delays investment, whereas an increase in the degree of market completeness can have a non-monotonic effect on investment.

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