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Journal of Finance Vol. 65 No. 5 2010

A Bayesian Approach to Real Options: The Case of Distinguishing between Temporary and Permanent Shocks

Steven R. Grenadier1; Andrey Malenko2,3,4

1 Stanford Graduate School of Business · 2 University of Michigan–Ann Arbor · 3 Ross School · 4 Centre for Economic Policy Research

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Abstract

Traditional real options models demonstrate the importance of the “option to wait” due to uncertainty over future shocks to project cash flows. However, there is often another important source of uncertainty: uncertainty over the permanence of past shocks. Adding Bayesian uncertainty over the permanence of past shocks augments the traditional option to wait with an additional “option to learn.” The implied investment behavior differs significantly from that in standard models. For example, investment may occur at a time of stable or decreasing cash flows, respond sluggishly to cash flow shocks, and depend on the timing of project cash flows.

DOI
10.1111/j.1540-6261.2010.01599.x
Volume
65
Issue
5
Pages
1949-1986
Language
en
Sources
bibtex:phds-export.bib crossref openalex

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