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- Title
Real Option Valuation in a Gollier/Weitzman World: The Effect of Long-Run Discount Rate Uncertainty.
- Authors
Tandja M., Djerry C.; Power, Gabriel J.; Bastien, Josée
- Abstract
Large-scale investment projects face significant long-run uncertainty in interest rates. However, little is known about the effect of long-term discount rate uncertainty on capital investment real option values. This paper bridges the long-run discount rate uncertainty literature developed in climate change economics with the financial literature on interest rate models and real options. First, we derive an Ingersoll-Ross real option model under the assumption of a declining discount rate model (DDR) following Gollier and Weitzman, and show how optimal investment timing is affected. Second, we study the problem of an open oil field with an abandonment option. We find that, compared with DDR, standard models using constant or mean-reverting interest rates undervalue projects and their real options to wait or to abandon. Indeed, results under DDR are more consistent with recent evidence on corporate decision-making under incomplete preferences or ambiguity. The results have implications for both energy investment under uncertainty and climate finance.
- Subjects
INVESTMENTS; INTEREST rates; ECONOMIC development; PRICE inflation; FINANCIAL markets
- Publication
Energy Journal, 2018, Vol 39, Issue 5, p21
- ISSN
0195-6574
- Publication type
Article
- DOI
10.5547/01956574.39.5.dtan