Optimal investment under operational flexibility, risk aversion, and uncertainty

• Main Authors: CHRONOPOULOS, Michail, DE REYCK, Bert, SIDDIQUI, Afzal
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2011
• Subjects: Decision analysis; Investment under uncertainty; Real options; Operational flexibility; Risk aversion; Operations and Supply Chain Management; Risk Analysis
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/6755; https://ink.library.smu.edu.sg/context/lkcsb_research/article/7750/viewcontent/Optimal_investment_under_operational_flexibility_risk_aversion_av.pdf
• Institution: Singapore Management University

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.