Investment Timing Under Regime Switching

35 Pages Posted: 20 Feb 2007 Last revised: 10 Feb 2018

See all articles by Robert J. Elliott

Robert J. Elliott

University of Calgary - Haskayne School of Business; University of Alberta - Department of Mathematical and Statistical Sciences; University of South Australia

Hong Miao

Colorado State University, Fort Collins - Department of Finance & Real Estate

Jin Yu

Vienna Graduate School of Finance (VGSF)

Multiple version iconThere are 2 versions of this paper

Date Written: February 16, 2007

Abstract

This paper is intended to elaborate regime switching and optimal investment timing in a real option framework. The paper differs from the existing literature in a significant way. In this paper we first consider an irreversible investment timing decision by adding a hidden Markov process to model the state of the economy in continuous time. The cost of the investment is driven the Markov chain. Therefore, the investment cost is either K_1 or K_2 depending on whether the economy is in a low cost or high cost state. K_1 and K_2 can be considered as strike prices of a perpetual American option. This is reasonable as people do observe business cycles of macroeconomic variables that determine the investment costs of the project. By introducing this specific structure of stochastic investment costs, the paper presents a different optimal exercising policy for the firm. It is optimal for the firm to exercise much earlier than otherwise suggested by a standard real option model. Moreover, a range of exercising trigger prices is determined. Of course, the value of the growth option that the firm faces is also higher than the one derived by a conventional real option model. Thus, we show that an optimal timing policy suggested by the conventional real option model might ruin the investment opportunities.

The main contribution of our paper is to overcome the limitations discussed above. We assume, instead, that the investment costs follow a Markov chain with a finite state space, though for convenience of exposition we restrict our analysis to a two state Markov chain. This model confines the uncertainty of the investment cost to a controllable range instead of diffusively moving from zero to infinity. Moreover, by calibrating the parameters in our model, that is the elements in the Q-matrix, it is possible to have our stochastic investment cost return to its equilibrium level in the long run. Hence, our assumption of regime switching investment cost is less misspecified than ones with constant or stochastic costs driven by Brownian motions.

Keywords: Investment Timing, Real Option, Regime Switching

JEL Classification: G31

Suggested Citation

Elliott, Robert James and Miao, Hong and Yu, Jin, Investment Timing Under Regime Switching (February 16, 2007). International Journal of Theoretical and Applied Finance, Vol. 12, 2009, Available at SSRN: https://ssrn.com/abstract=963962 or http://dx.doi.org/10.2139/ssrn.963962

Robert James Elliott (Contact Author)

University of Calgary - Haskayne School of Business ( email )

2500 University Drive, NW
Calgary, Alberta T2N 1N4
Canada

University of Alberta - Department of Mathematical and Statistical Sciences ( email )

Edmonton, Alberta T6G 2G1
Canada
403-492-5811 (Phone)
403-492-6826 (Fax)

University of South Australia ( email )

37-44 North Terrace
Adelaide
Australia

Hong Miao

Colorado State University, Fort Collins - Department of Finance & Real Estate ( email )

Fort Collins, CO 80523
United States

Jin Yu

Vienna Graduate School of Finance (VGSF) ( email )

1190, Heiligenstaedter Strasse 46-48
Vienna, 1190
Austria
+43-1-31336-6319 (Phone)
+43-1-31336-906319 (Fax)

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