Investment-uncertainty Relationship Research Articles

On the Investment-Uncertainty Relationship in a Real Option Model with Stochastic Volatility

We consider the classical investment timing problem in a framework where the instantaneous volatility of the project value is itself given by a stochastic process, hence lifting the old question about the investment-uncertainty relationship to a new level. Motivated by the classical cases of Geometric Brownian Motion (GBM) and Geometric Mean Reversion (GMR), we consider processes of similar functional form, but with Heston stochastic volatility replacing the constant volatility in the classical models. We refer to these processes as Heston-GBM and Heston-GMR. For these cases we derive asymptotic solutions for the investment timing problem using the methodology introduced by Fouque et. al. (2000). In particular we show that compared to the classical cases with constant volatility, the question of whether additional stochastic volatility increases or decreases the investment threshold depends on the instantaneous correlation between the project value and the stochastic volatility. For the case of Heston-GBM we provide a closed form expression that measures this effect quantitatively, for the case of Heston-GMR we derive the sign of the effect analytically, using a type of maximum principle for ODEs. Various numerical examples are discussed and a comparative analysis is provided.

Testing the uncertainty–investment relationship using survey data on capital stock disequilibrium

This article uses unique survey-based data that record the extent of positive and negative disequilibrium in capital stock at industry level. Change in these disequilibria are hypothesized to take account of planned and revised targets, and the influence of uncertainty on adjustment. We find that increased uncertainty slows the adjustment of fixed capital towards equilibrium levels. That is consistent with the predictions of real options theory and partial irreversibility models.

Re-examining the investment-uncertainty relationship in a real options model

The main purpose of this paper is to re-examine the investment-uncertainty relationship in a real options model, and demonstrates that the Sarkar (J Econ Dyn Control 24:219–225, 2000) model is a special case of our model. This paper uses a general dynamic process, which incorporates mean reversion and jumps in a firm’s project earnings. We further derive a quasi-analytical form solution for the critical investment value and investment probability of a firm’s projects. From the simulation results, we find that an increase in uncertainty can always lead to an increase in the probability of investment, and thus has a positive impact on investment. These results, which differ from the findings of Sarkar (J Econ Dyn Control 24:219–225, 2000), could be explained by the mean-reversion and jump effects on a firm’s earnings.

A Framework of Monte Carlo Simulation for Examining the Uncertainty-Investment Relationship

A Framework of Monte Carlo Simulation for Examining the Uncertainty-Investment Relationship

Why demand uncertainty curbs investment: Evidence from a panel of Italian manufacturing firms

Theoretically, the effect on investment of uncertainty over the demand for a firm’s product is unclear because of the influence of several factors, such as the production technology and the amount of competition in the product market. It has not been possible, until now, to investigate more closely the interplay of different factors in the time dimension because the empirical research has been based on cross-section analysis. This omission makes biased estimates of the investment-uncertainty relationship likely. The aim of this paper is to extend the findings of the empirical literature using a panel of Italian firms in the period 1996–2004, covering a complete business cycle. The availability of panel survey data on companies’ investment plans, expected future sales and demand uncertainty allows us to account for unobservable individual differences between firms, macroeconomic shocks and the evolution of the investment–uncertainty relationship. A key finding of our paper concerns the role of the competition encountered by Italian firms in 1996–2004. The gradual loss of market power over time of Italian manufacturing firms, along with the increasing flexibility of labour input has weakened the negative effect of uncertainty on investment decisions. We show that, in repeated cross-section estimates, the omission of firm-specific effects together with the dynamic interplay described above, would have lead to misleading conclusions about the relevance of demand uncertainty in explaining investment decisions.

INTEGRATED PRODUCTION AND THE INVESTMENT–UNCERTAINTY RELATIONSHIP

AbstractThis paper studies the role of production mode in determining the effects of an increase in uncertainty on the choice of investment outlay. In a continuous‐time model of optimal capital investment with innovative R&D under demand uncertainty, we show that investments in both capital and innovative research decrease with an increase in uncertainty, and that such investments rise with the level of primary demand. Our result sheds light on the mode of production as a source of the negative investment–uncertainty relationship.

Time-to-Build and the Inverse U-Shape Investment-Uncertainty Relationship

The effect that investment lags have on the uncertainty-investment relationship is studied by modifying the Bar-Ilan and Strange (1996) model to enable an analytical solution. The following results emerge: (i) If the time lag is sufficiently small, uncertainty affects investment negatively; (ii) A sufficiently large time lag gives rise to an inverse U-shape uncertainty-investment relationship; (iii) When such an inverse U-shape exists, the longer the time lag (or the larger the degree of profit convexity), the wider the range of a positive uncertainty-investment relationship.

The R&D Investment-Uncertainty Relationship: Do Competition and Firm Size Matter?

This paper investigates how competition and firm size affect the relationship between market uncertainty and R&D investment. We use an intuitively appealing measure of firm-specific uncertainty along with panel data to show that firms invest less in current R&D as uncertainty about market returns increases. The effect of firm-specific uncertainty on R&D investment is smaller in concentrated markets – those where market power is higher and strategic rivalry is more intense. Further, the effect of uncertainty on R&D investment is attenuated for large firms which may be the result greater economies of scope.

Why Demand Uncertainty Curbs Investment: Evidence from a Panel of Italian Manufacturing Firms

From a theoretical point of view, uncertainty over the demand for a firm's product may not have clear effects on investments, because of the influence of a number of factors, such as the production technology and the amount of competition in the product market. Until now, a deeper investigation of the interplay of different factors in the temporal dimension has not been possible because the empirical research has been based on cross-section analysis. This omission makes biased estimates of the investment-uncertainty relationship likely. The aim of this paper is to extend the findings of the empirical literature by using a panel of Italian firms over the period 1996-2004, covering a complete business cycle. The availability of a panel of survey data on companies' investment plans, expected future sales and demand uncertainty allows us to account for unobservable individual firm differences, macroeconomic shocks and the temporal evolution of the investment-uncertainty relationship. A key finding of our paper concerns the role of the competition faced by Italian firms in 1996-2004. The gradual loss of market power experienced by Italian manufacturing firms along with the increasing flexibility of labour input may have weakened the negative effect of uncertainty on investment decisions. We show that, in repeated cross-section estimates, the omission of firm-specific effects together with the dynamic interplay described above, would have lead to misleading conclusions about the relevance of demand uncertainty in explaining investment decisions.

Devaluating projects and the investment–uncertainty relationship

Sarkar (2000. On the investment–uncertainty relationship in a real options model. Journal of Economic Dynamics and Control, 24, 219–225) analyzes the investment–uncertainty relationship in a real-options model demonstrating that the widely accepted conclusion that uncertainty harms investment can be reversed. Wong (2006. The effect of uncertainty on investment timing in a real options model. Journal of Economic Dynamics and Control, forthcoming) confirms this point showing that more uncertainty can reduce the expected time to exercise the investment option. This paper deals with such an issue and attempts to integrate both Sarkar's and Wong's analysis. For risk-neutral investors, we show that uncertainty can favor investment only if projects devaluate over time. This conclusion does not hold in a CAPM framework, where we demonstrate that the relationship uncertainty/investment can be positive (a) even when the investment threshold increases with uncertainty and (b) in the case of projects negatively correlated with the market portfolio.

Investment Under Uncertainty

A real options theory—in its classic formulation—suggests that firms invest less during times of high uncertainty, that is, uncertainty depresses investment. However, several theoretical extensions predict that the relationship between investment and uncertainty may be non-linear, or even non-monotonic, when classic model assumptions are violated. Some model parameters either reinforce or weaken the negative effect of uncertainty on investment, while others distort the investment-uncertainty relationship, making it follow an inverted U-curve. This paper is a first—to my knowledge—attempt to identify the factors affecting investment from various streams of theoretical literature on investor choice and uncertainty, and to assemble them in a single empirical framework. By employing a dynamic panel of oil company data and implied volatilities as measures of uncertainty, I am able to examine the impact of uncertainty on investment and the effect of several factors on the investment-uncertainty relationship. I obtain evidence in support of several predictions from the theory. Both economy-wide and firm-specific types of uncertainty, as well as financing constraints, are found to adversely affect investment, while industry-wide uncertainty has an ambiguous effect, depending on the level of output price. In tests for non-linearity in the investment-output price volatility relationship, I find that output price, firm size and its risk management ability weaken the investment-uncertainty relationship. On the other hand, market imperfection, financing constraints, the firm’s maturity and its risk aversion re-enforce the negative effect of uncertainty. In addition, adjustment costs seem to be considerable, as firm investment reacts to changes in macroeconomic conditions with a noticeable delay.

Risk aversion, intertemporal substitution, and the aggregate investment–uncertainty relationship

We analyze the role of risk aversion and intertemporal substitution in a simple dynamic general equilibrium model of investment and savings. Our main finding is that risk aversion cannot by itself explain a negative relationship between aggregate investment and aggregate uncertainty, as the effect of increased uncertainty on investment also depends on the intertemporal elasticity of substitution. In particular, the relationship between aggregate investment and aggregate uncertainty is positive even if agents are very risk averse, as long as the elasticity of intertemporal substitution is low. A negative investment–uncertainty relationship requires that the relative risk aversion and the elasticity of intertemporal substitution are both relatively high or both relatively low. We also show that the implications of our model are consistent with the available empirical evidence.

Risk-aversion and the investment–uncertainty relationship: The role of capital depreciation

Some recent contributions [Nakamura, T., 1999. Risk-aversion and the uncertainty–investment relationship: a note. Journal of Economic Behavior and Organization 38, 357–363; Saltari, E., Ticchi, D., 2005. Risk-aversion and the investment–uncertainty relationship: a comment. Journal of Economic Behavior and Organization 56, 121–125] suggest that investments react negatively to uncertainty when the risk aversion index characterizing firm’s preferences is lower than one but higher than the labour income share of output. We show that this result crucially depends on the assumption of complete capital depreciation after production. When realistic values for the capital depreciation parameter are taken into account, the investment–uncertainty relation is negative for values of the risk-aversion index larger than unity.

A note on uncertainty and investment across the spectrum of irreversibility

There is a lack of consensus regarding the sign of the uncertainty-investment relationship, with a strand of the literature suggesting a positive sign, and the Real Options Theory (ROT) advocating a negative relationship. As a way of testing the ROT, this paper empirically investigates its main prediction that the negative effect of uncertainty on investment is an increasing function of the degree of irreversibility. Empirical results provide support for the ROT since uncertainty is found to exert a higher impact on investment spending across the irreversibility spectrum.

The effect of uncertainty on investment timing in a real options model

This paper examines the effect of uncertainty on investment timing in a canonical real options model. We show that the critical value of a project that triggers the exercise of the investment option exhibits a U-shaped pattern against the volatility of the project. This is due to the two countervailing risk and return factors in effect. We further show that such a U-shaped pattern is inherited by the expected time to exercise the investment option. Thus, for relatively safe projects, greater uncertainty shortens the expected exercise time and thus enhances investment. This is in sharp contrast to the negative investment–uncertainty relationship commonly found in the extant literature. Finally, we show that the positive investment–uncertainty relationship is more likely for high growth projects than for low growth projects.

RISK‐AVERSION, OPTIMAL LEVERAGE AND THE INVESTMENT–UNCERTAINTY RELATION

ABSTRACTWe develop a partial equilibrium dynamic model in which firms are risk‐averse. We analyse the determinants of the investment–uncertainty relationship by means of numerical techniques. When firms can borrow ‘outside’ resources at the riskless rate, an increase in price volatility depresses investment for realistic parameter values. In our model, portfolio considerations play an important role. When the marginal revenue of capital becomes more uncertain, the risk‐averse firm's owners reduce their ‘short position’ in the risk‐free asset, thus diminishing the firm's debt level. The contraction in leverage reduces the expected returns on investment because the expected marginal revenue product is higher than the user cost of capital. In turn, the reduction in expected yields tends to depress investment.

Is the Investment–Uncertainty Relationship Nonlinear? An Empirical Analysis for the Netherlands

We examine the investment–uncertainty relationship for a panel of Dutch non‐financial firms. The system generalized method of moments (GMM) estimates suggest that the effect of uncertainty on investment is nonlinear: for low levels of uncertainty an increase in uncertainty has a positive effect on investment, while for high levels of uncertainty an increase in uncertainty lowers investment. This result is in line with a number of theoretical studies, but has never been documented empirically.

Lags, Convexity and the Investment-Uncertainty Relationship

The effect that investment lags has on the uncertainty-investment relationship is studied by modifying the Bar-Ilan and Strange (1996) model in a manner that enables analytical solution. It turns out that: (i) If the time lag is sufficiently small, uncertainty affects investment negatively; (ii) A sufficiently large time lag engenders an inverse u-shape relationship between the degree of uncertainty and the profit level that triggers investment; (iii) When such an inverse u-shape exists, the higher is the length of the time lag (or the degree of profit convexity) the wider is the range of a positive uncertainty-investment relationship.

How to analyze the investment–uncertainty relationship in real option models?

The real options tradition originally predicted a decreasing relationship between uncertainty and investment, through the positive effect of higher uncertainty on the trigger level for revenue relative to costs. An opposing effect on the probability of reaching the level has been identified, yielding a total effect with ambiguous sign. This paper makes three points. The “opposing” effect is not always opposing. Systematic risk cannot generally be assumed to increase with volatility. A probability is not the best measure of investment. The sign of the total effect is again ambiguous. This ambiguity is illustrated, depending on specification of model and parameters.

Risk-aversion and the investment–uncertainty relationship: a reply

Risk-aversion and the investment–uncertainty relationship: a reply