Neng Wang

Risk, Uncertainty, and Option Exercise

Coauthor(s): Jianjun Miao.

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Abstract:

Many economic decisions can be described as an option exercise or optimal stopping problem under uncertainty. Motivated by experimental evidence such as the Ellsberg Paradox, we follow Knight (1921) and distinguish risk from uncertainty. To afford this distinction, we adopt the multiple-priors utility model. We show that the impact of ambiguity on the option exercise decision depends on the relative degrees of ambiguity about continuation payoffs and termination payoffs. Consequently, ambiguity may accelerate or delay option exercise. We apply our results to investment and exit problems, and show that the myopic NPV rule can be optimal for an agent having an extremely high degree of ambiguity aversion.

The PDF above is a preprint version of the article. The final version may be found at < http://dx.doi.org/10.1016/j.jedc.2010.11.005 >.

Source: Journal of Economic Dynamics & Control
Exact Citation:
Wang, Neng, and Jianjun Miao. "Risk, Uncertainty, and Option Exercise." Journal of Economic Dynamics & Control 35 (2011): 442-461.
Volume: 35
Pages: 442-461
Date: 2011