Title: On the Investment-Uncertainity Relationship
Reference Number: 1181
Publication Date: January 2008
JEL Classifcation: D21, D81, G13

Kit Pong Wong
The University of Hong Kong

This paper examines the investment-uncertainty relationship in a canonical real options model. We show that the critical lump-sum payoff of a project that triggers the exercise of the investment option exhibits a U-shaped pattern against the volatility of the project. This is driven by two opposing effects of an increase in the volatility of the project: (i) the usual positive effect on option value, and (ii) a negative effect on option value due to the upward adjustment in the discount rate. We further show that such a U-shaped pattern is inherited by the expected time to exercise the investment option. Thus, for relatively safe projects, greater uncertainty may in fact shorten the expected exercise time and thereby enhance investment. This is in sharp contrast to the negative investment-uncertainty relationship as commonly suggested in the extant literature.

Key words: Real options, Investment timing, Uncertainty

Last modified: 01/15/2008