Irreversible Investment and Discounting: An Arbitrage Pricing Approach

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

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