Irreversible Investment and Discounting: An Arbitrage Pricing Approach

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JournalAnnals of FInance
DatePublished - Jul 2010
Issue number3
Volume6
Number of pages21
Pages (from-to)295-315
Original languageEnglish

Abstract

This paper presents a unified approach to valuing investment projects under uncertainty, based on stochastic discount factors, by linking optimal stopping theory to the no-arbitrage principle in asset pricing. An investment threshold for the case where the discount factor and the project’s cash-flow both follow a geometric Brownian motion is derived. Comparative statics of the investment trigger are obtained adding to and clarifying on the uncertainty–investment debate. Finally, two different ways to obtain discount factors are illustrated: spanning assets and representative agent analysis. The link between the characteristics of these different approaches and the optimal investment policy is clarified.

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