Template-Type: ReDIF-Paper 1.0

Author-Name: Junjian Miao
Author-X-Name-First: Junjian
Author-X-Name-Last: Miao
Author-Email: miaoj@bu.edu
Author-Workplace-Name: Department of Economics, Boston University

Author-Name: Neng Wang
Author-X-Name-First: Neng
Author-X-Name-Last: Wang
Author-Email: neng.wang@columbia.edu
Author-Workplace-Name: Columbia Business School

Title: Investment, Consumption and Hedging under Incomplete Markets

Abstract: Entrepreneurs often face undiversiŻable idiosyncratic risks from their business invest-
ments. Motivated by this observation, we extend the standard real options approach to
investment to an incomplete markets environment and analyze the joint decisions of busi-
ness investments, consumption-saving and portfolio selection. Our analysis depends cru-
cially on whether the investment payoŽs are in lump-sum or in °ows. Precautionary saving
eŽect plays a key role. In the lump-sum payoŽ case, risk aversion accelerates investment.
Moreover, when the agent's precautionary motive is strong enough, an increase in volatility
accelerates investment. These results may be reversed for the °ow payoŽ case. Finally,
hedging aŽects investment decisions by changing the expected growth of wealth and reduc-
ing the agent's exposure to idiosyncratic risk. The agent's hedging demand is higher when
he is closer to exercising the investment option.

Length: 42 pages
Creation-Date: 2005-10
Revision-Date: 2006-09
Publication-Status: published, Journal of Financial Economics 86 (2007), 608-642
File-URL:http://people.bu.edu/miaoj/MiaoWangJFE.pdf
File-Format: Application/pdf
File-Function: 
Number: WP2005-011
Classification-JEL: G11, G31, E2
Keywords: real options, idiosyncratic risk, hedging, risk aversion, precautionary saving,incomplete markets
Handle: RePEc:bos:macppr:WP2005-011