| Abstract: |
Entrepreneurs often face undiversifiable idiosyncratic risks from their
business investments. We extend the standard real options approach to an
incomplete markets environment and analyze the joint decisions of business
investments, consumption/savings, and portfolio selection. For a lump-sum
investment payoff and an agent with a sufficiently strong precautionary
savings motive, an increase in volatility can accelerate investment, contrary
to the standard real options analysis. When the agent can trade the market
portfolio to partially hedge against investment risk, the systematic
volatility is compensated via the standard CAPM argument, and the
idiosyncratic volatility generates a private equity premium. Finally, when the
investment payoff is a series of flows, the agent's idiosyncratic risk
exposure alters both the implied option value and the implied project value,
causing a reversal of the results in the lump-sum payoff case. |