TY  - JOUR
AU  - Miao,Jianjun
AU  - Wang,Neng
TI  - Investment, Consumption, and Hedging under Incomplete Markets
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 13250
PY  - 2007
Y2  - July 2007
UR  - http://www.nber.org/papers/w13250
L1  - http://www.nber.org/papers/w13250.pdf
N1  - Author contact info:
Jianjun Miao
Department of Economics
Boston University
270 Bay State Road
Boston MA 02215
E-Mail: miaoj@bu.edu

Neng Wang
Columbia Business School
3022 Broadway, Uris Hall 812
New York, NY 10027
Tel: 212/854-3869
Fax: 212/662-8474
E-Mail: nw2128@columbia.edu
AB  - 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.
ER  -