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Optimal investment under operational flexibility, risk aversion, and uncertainty

Chronopoulos, M; De Reyck, B; Siddiqui, A; (2011) Optimal investment under operational flexibility, risk aversion, and uncertainty. EUR J OPER RES , 213 (1) 221 - 237. 10.1016/j.ejor.2011.03.007.

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Abstract

Traditional real options analysis addresses the problem of investment under uncertainty assuming a risk-neutral decision maker and complete markets. In reality, however, decision makers are often risk averse and markets are incomplete. We confirm that risk aversion lowers the probability of investment and demonstrate how this effect can be mitigated by incorporating operational flexibility in the form of embedded suspension and resumption options. Although such options facilitate investment, we find that the likelihood of investing is still lower compared to the risk-neutral case. Risk aversion also increases the likelihood that the project will be abandoned, although this effect is less pronounced. Finally, we illustrate the impact of risk aversion on the optimal suspension and resumption thresholds and the interaction among risk aversion, volatility, and optimal decision thresholds under complete operational flexibility. (C) 2011 Elsevier B.V. All rights reserved.

Type:Article
Title:Optimal investment under operational flexibility, risk aversion, and uncertainty
DOI:10.1016/j.ejor.2011.03.007
Keywords:Decision analysis, Investment under uncertainty, Real options, Operational flexibility, Risk aversion, PROJECTS, OPTION, TIME
UCL classification:UCL > School of BEAMS > Faculty of Engineering Science > Management Science and Innovation
UCL > School of BEAMS > Faculty of Maths and Physical Sciences > Statistical Science

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