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Real options with overextrapolation

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Author
Jiaxin Peng
Category
Financial
Date Posted
2022/09/01
Date Retrieved
2023/03/17
Date Revised
Date Written
2022/09/01
Description
This study incorporates the overextrapolation belief into the classic real options model. Using the stochastic dynamic programming method we obtain the semiclosed-form solutions for the optimal investment and valuation of real options and the welfare loss owing to overextrapolation. The theoretical results show that overextrapolation has significant effects on the investment and pricing which depend on the belief that overextrapolation induces the agent to underinvest in and undervalue the option with low belief concerning the anticipated return. Conversely overextrapolation leads to overinvestment and overvaluation for agents with high belief. Moreover our model predicts that welfare loss owing to distorted investment due to overextrapolation is inessential.
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JEL Classifications
G31; G11; G12; C13
Keywords
Real option; Overextrapolation; Investment; Welfare loss
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