Electronic copy available at: http://ssrn.

com/abstract=422600
Real options and risk aversion

Julien Hugonnier
University of Lausanne
and Swiss Finance Institute
Erwan Morellec

University of Lausanne
Swiss Finance Institute and CEPR
September 2007

We thank Mike Barclay, Jean-Pierre Danthine, Cli Smith, Jerry Zimmerman,

and seminar participants at the University of Rochester for helpful comments. Fi-
nancial support from the Swiss Finance Institute and from the National Center of
Competence in Research Financial valuation and risk management (NCCR Fin-
Risk) is gratefully acknowledged.

Corresponding author. Postal address: HEC University of Lausanne, Batiment

Extranef, CH1015 Switzerland. Email address: Erwan.morellec@unil.ch
Electronic copy available at: http://ssrn.com/abstract=422600
Abstract
In the standard real options approach to investment under uncertainty,
agents formulate optimal policies under the assumptions of risk neutral-
ity or complete nancial markets. Although these assumptions are crucial
to the implications of the approach, they are not particularly relevant to
most real world environments where agents face incomplete markets and are
exposed to undiversiable risks. In this paper we extend the real options
approach to incorporate risk aversion for a general class of utility functions.
We show that risk aversion provides an incentive for the investor to delay
investment and leads to a signicant erosion in project values.
Keywords: Risk aversion; Real options; Investment timing.
JEL Classication: G31.
Electronic copy available at: http://ssrn.com/abstract=422600
1 Introduction
Since the seminal contributions of McDonald and Siegel (1986) and Pindyck
(1988), the literature analyzing investment decisions under uncertainty has
developed substantially.
1
In this literature, investment opportunities are an-
alyzed as options written on real assets and the optimal investment policy
is derived by maximizing the value of the option to invest. Because option
values depend on the riskiness of the underlying asset, volatility is an impor-
tant determinant of the value-maximizing investment policy. As a result, one
would expect attitudes toward risk to signicantly aect investment policy.
Despite this observation, real options models typically presume that deci-
sion makers are risk neutral or that markets are complete and frictionless,
so that decisions are made in a preference-free environment.
Although the assumptions of risk neutrality or market completeness are
crucial to the implications of the approach, they are not particularly rele-
vant to most real-world environments. In particular, corporate executives
and entrepreneurs typically have to make investment decisions in situations
where they face incomplete markets and are exposed to undiversiable risks.
This exposure may arise because the cash ows from the investment project
are not spanned by those of existing assets; this is typically the case of R&D
projects or more generally of investments in new lines of business. It may
also arise because of compensation packages that constrain corporate exec-
utives to hold very undiversied positions in their rms stock. Finally, it
may simply arise because of transaction costs or other types of capital mar-
ket imperfections. In such situations where decision makers are exposed to
undiversiable risks, investment decisions should depend on their attitudes
towards risk. This then begs the question: How does risk aversion aect
investment decisions?
This paper develops a utility-based framework that answers this ques-
1
Dixit and Pindyck (1994) provide an excellent survey of this literature. See Moel and
Tufano (2002) for empirical evidence.
1
tion. To make the intuition as clear as possible, we construct a simple model
of investment decisions that builds on earlier work by McDonald and Siegel
(1986). Specically, we consider an entrepreneur with exclusive access to a
project that generates a continuous stream of cash ows. The entrepreneur
has perpetual rights to the project and seeks to determine the investment
date that maximizes his expected utility of future consumption. Investment
is irreversible and, by investing, the entrepreneur gives up the valuable op-
tion to wait for new information. As a result, investment arises when the
subjective valuation of the project equals the full investment cost, which
includes the subjective value of the option of waiting.
The analysis in the paper reveals that risk aversion has a large impact
on investment policy and project value. Notably, the dierence in project
value under rm- and utility-maximizing policies can reach 20% for reason-
able parameter values. As shown in the paper, this erosion in values arises
because the decision maker has a strong incentive to delay investment, as
manifested by his decision to select an investment threshold that is too high
relative to the value-maximizing threshold. The intuition underlying this
result is as follows. By investing, the decision maker transforms a safe asset
into a risky one. This exposes him to undiversiable cash ow risk. The
associated increase in the volatility of consumption leads to a reduction in
his indirect utility, which in turn provides him with an incentive to delay
investment.
The remainder of paper is organized as follows. Section two describes the
model. Section three analyzes investment decisions. Section four discusses
implications. Section ve concludes. Technical developments are gathered
in the Appendix.
2 Model and assumptions
This paper analyzes the impact of risk aversion on rms investment deci-
sions. For doing so, we consider a simple generalization of McDonald and
2
Siegel (1986) in which an entrepreneur has exclusive access to a project that
generates a continuous stream of cash ows after the investment date. We
presume that these cash ows are not spanned by those of existing assets.
That is, the entrepreneur faces incomplete markets. In addition to this in-
vestment opportunity, the entrepreneur has wealth I that is invested in a
risk free technology yielding an instantaneous return r > 0.
At any time, the entrepreneur can invest his wealth in a risky project.
As in McDonald and Siegel (1986) we consider that the investment decision
is irreversible. Moreover, we assume that the project is innitely lived and
generates an instantaneous cash ow stream X that is governed by the
diusion:
dX
t
= X
t
dt + X
t
dZ
t
, X
0
= x > 0.
In this equation, and > 0 are constant parameters and Z is a standard
Brownian motion. This equation implies that, over a interval of length t,
the growth rate of cash ows is normally distributed with mean t and
variance
2
t.
Throughout the paper, the preferences of the decision maker are repre-
sented by the expected utility function
c E
_
_

0
e
t
U (c
t
) dt
_
,
where U is his utility function and is his subjective rate of time preference.
The function U is dened on the interval (a, ) for some a 0 and is
assumed to increasing, concave and once continuously dierentiable. Thus
our model can accommodate the case of a risk neutral decision maker as
well as any of the standard CARA, CRRA, and HARA utility functions.
3
3 Real options and investment timing
3.1 The benchmark case: risk neutrality
We rst review the problem studied by McDonald and Siegel (1986) as
presented in Dixit and Pindyck (1994,Chapter 6).
Assume that the decision maker is risk neutral and that his subjective
discount rate satises = r > . In that case, the objective of the decision
maker is to determine the investment policy that maximizes project value.
By investing in the project, the decision maker gives up a risk-free cash
ow stream rI and gets in return a risky cash ow stream X. Thus, his
problem is to select the investment time that solves the following problem:
v(x) sup
S
E
x
_
_

0
e
rs
rIds +
_

e
rs
X
s
ds
_
where S denotes the set of stopping times of the ltration generated by
the cash ow process and E
x
is the expectation operator conditional on the
initial value X
0
= x of the cash ow process.
Using the strong Markov property of the cash ow process this optimiza-
tion problem can also be written as
v(x) = I + F(x)
where
F(x) = sup
S
E
x
_
_

e
rs
(X
s
rI) ds
_
denotes the value of the investment opportunity. Because the current cash
ow is a sucient statistic for the investment surplus and this surplus is
increasing in X, the value-maximizing investment policy takes the form of a
trigger policy that can be described by a rst passage time of the cash ow
4
process to a constant threshold X

. Standard calculations give

F(x) =
_
x
X

_
X

r
I
_
where > 1 is the positive root of the quadratic equation
1
2

2
( 1) + r = 0.
Equation (3.1) shows that the value of the investment project (F ()) equals
the product of the investment surplus (rst factor on the right hand side of
equation (3.1)) and a stochastic discount factor ((x/X

) which accounts
for both the timing of investment and the probability of investment. Us-
ing this equation, it is then immediate to show that the value-maximizing
investment threshold satises:
X

r
=

1
I.
Equation (3.1) gives the critical value of the cash ow process at which it
is optimal to invest. Because > 1, we have X

> (r ) I and it follows

that it is optimal to invest when the projects net present value is strictly
positive. Thus, irreversibility and the ability to delay lead to a range of
inaction even when the investment surplus is positive. We now turn to the
analyzing the impact of risk aversion on investment decisions.
3.2 Investment timing and risk aversion
While the assumptions of risk neutrality or market completeness are conve-
nient to characterize investment decisions under uncertainty, they are not
particularly relevant to most real-world applications. In particular, corpo-
rate executives and entrepreneurs typically have to make investment deci-
sions in situations where the cash ows from the project are not spanned
by those of existing assets or under other constraints which that make them
5
face incomplete markets.
2
In such environments, we can expect their risk
aversion to aect rms investment decisions.
How does risk aversion aect investment decisions? Within the present
paper the decision maker is risk averse and faces incomplete markets. By
investing in the project, he gives up a risk-free cash ow stream rI and gets
in return an undiversiable risky cash ow stream X. Thus, his problem is
to select the investment time that solves the following problem:
u(x) sup
S
E
x
_
_

0
e
s
U(rI)ds +
_

e
s
U(X
s
)ds
_
.
This optimization problem can also be written as
u(x) =
U(rI)

+ F(x)
where
F(x) = sup
S
E
x
_
_

e
s
(U(X
s
) U(rI)) ds
_
.
This specication shows that the indirect utility of the decision maker is the
sum of the utility he would derive ignoring the investment option plus the
expected change in utility due to the exercise of the option.
Using the law of iterated expectations and the strong Markov property
of the cash ow process, we can write
F(x) = sup
S
E
x
_
e

V (X

2
These liquidity restrictions can be imposed on executives for legal reasons (SEC Rule
144). They can also be imposed by contract (lockup periods in IPOs or M&As, or vesting
periods in compensation packages). For example, on July 8, 2003 Microsoft announced
that employees would receive common stock with a minimum holding period of ve years.
Kole (1997) documents that, in her sample, the minimum holding period before any shares
can be sold ranges from 31 to 74 months. In addition, for more than a quarter of the plans,
the stock cannot be sold before retirement.
6
where the function V () is dened by
V (x) E
x
_
_

0
e
s

U(X
s
)ds
_
for

U(x) U(x) U(rI). As in the risk neutral case, the investment
surplus is an increasing function of the current cash ow. Thus, the utility
maximizing investment policy can be described by a rst passage time of
the cash ow process to a constant threshold.
Denote by and the positive and negative roots of the quadratic
equation
1
2

2
( 1) + = 0.
Solving for the utility maximizing threshold yields the following result.
Theorem 1. Assume that the value function F() is nite. Then the indirect
utility of the decision maker satises
u(x) :=
1

U(rI) + V (X

)
_
min{x, X

}
X

where the function V () is dened by

V (x) =
2

2
( )
_
x

_
x
0
s
1

U (s) ds + x

_

x
s
1

U (s) ds
_
,
and the utility maximizing investment rule is to invest as soon as the cash
ow reaches the threshold dened by
X

inf
_
x > 0 :
_
x
0
s
1

U(s)ds 0
_
.
Theorem 1 provides the optimal investment policy for all increasing and
concave utility functions. To derive specic implications regarding the im-
pact of risk aversion on investment decisions, the model has to be specied
further. Below we examine these implications by considering the class of
7
constant relative risk aversion utility functions dened by:
U(x) =
x
1R
1 R
; R > 0.
In this specication, the constant R is the managers relative risk aversion
and, as usual, the case R = 1 corresponds to the logarithmic utility function.
A simple application of the result in Theorem 1 yields the following
Proposition.
Proposition 2. Assume that > , the decision maker has power utility
with constant relative risk aversion parameter R and that
+ (R 1)
_

1
2

2
R
_
is strictly positive. Then, the indirect utility function satises
u(x) =
1

U(rI) +
_
1

U(X

)
1

U(rI)
__
min{x, X

}
X

and the utility maximizing investment threshold is given by

X

= X

(R) rI
_

1 + R
_

__ 1
1R
.
Proposition 2 shows that under the assumption of constant relative risk
aversion the optimal investment threshold has the same functional form as
the one that maximizes project value. Specically, the minimum cash ow
value triggering investment is equal to the product of the cost of investment
and a factor that represents the value of waiting to invest.
While the expression for the value-maximizing investment threshold is
familiar from the real options literature, it is important to note that, within
the present model, this expression reects the attitude of the decision maker
towards risk. In particular, when the decision maker is risk neutral, we have
8
R = 0 and = r so that the investment threshold satises
X

(0)
r
=

1
I
which is the solution reported in equation (3.1) above.
Proposition 2 also shows that the indirect utility of the decision maker
is equal to the subjective value of the perpetual stream of consumption rI
plus the change in the subjective value of this stream associated with the
investment decision. Using the result of Proposition 2, we get
u(x) =
1

U (rI)
_
1 +
1 R
1 + R
_
x
X

(R)
_

_
, x X

(R),
where the second term inside the square brackets measures the increase in
indirect utility due to the exercise of the option.
3
4 Model implications
To determine the values of the quantities of interest, it is necessary to se-
lect parameter values for the initial value of the cash ow X
0
, the cost of
investment I, the risk free rate r, the growth rate of the cash ows , the
volatility of the cash ows (, ), the subjective discount rate and the
decision makers relative risk aversion R. The parameter values that we use
for the base case environment are reported in the following table.
Insert Table 1 here
The solution to the model presented in Proposition 2 yields a number of novel
implications regarding investment policy. These implications are grouped in
three categories as follows.
3
Note that when R > 1, the decision makers utility function is negative. In particular,
we have that U(rI) is negative and it follows that the subjective option value is positive.
9
4.1 Risk aversion and the option value to wait
One of the major contributions of the real options literature is to show that
with uncertainty and irreversibility, there exists a value of waiting to invest.
Thus, the decision maker should only invest when the asset value exceeds
the investment cost by a potentially large option premium [see e.g. Dixit
and Pindyck (1994)].
As shown in Proposition 1, this incentive to delay investment is magnied
by risk aversion. To better understand this incentive to delay investment,
one has to recall that by investing the entrepreneur transforms a safe asset
into a risky one. As a result, investment exposes him to undiversiable cash
ow risk. The associated increase in the volatility of consumption leads
to a reduction in the managers indirect utility, which in turn provides the
entrepreneur with an incentive to delay investment.
Insert Figure 1 here
This eect is illustrated by Figure 1 which plots the investment threshold
as a function of the relative risk aversion and the cash ow volatility.
4.2 Risk aversion and project value
The above analysis shows that a risk averse decision maker has an incentive
to delay investment in comparison with the value maximizing policy. As a
result, risk aversion induces a reduction in rm value which is equal to the
dierence between the rm values computed under the value maximizing
and utility maximizing investment policies.
Assume that = r > as in the base case environment and denote by
(x) E
x
_
_

0
e
rt
X
t
dt
_
=
x
r
the present value of the cash ows generated by the investment opportunity
conditional on the initial value X
0
= x. As a proportion of the value of the
10
rm under the value maximizing policy, the reduction in rm value due to
risk aversion is given by:
1
(X

(R)) I
(X

(0)) I
_
X

(0)
X

(R)
_

where X

(R) is the utility maximizing investment threshold and X

(0) is
the value maximizing investment threshold.
In base case environment, risk aversion reduces the value of the project
by 3.4%. Thus, risk aversion delays investment and has a signicant impact
on the value of investment projects. To get more insights on the impact of
the various parameters of the model, Figure 2 plots the reduction in project
value as a function of the decision makers relative risk aversion and the cash
ow volatility.
Insert Figure 2 here
Consistent with economic intuition, Figure 2 shows that the reduction in
project value increases with both volatility and the coecient of risk aver-
sion. Interestingly, this reduction in project value results from two opposite
eects. On the one hand, risk aversion increases the investment threshold
and hence the surplus from investment at the time of investment. On the
other hand, risk aversion delays investment and reduces the probability of
investment. This is to this second eect that we now turn.
4.3 Probability of investment
The impact of the decision makers risk aversion on the rms investment
policy can be analyzed by examining the change in the probability of invest-
ment. Dene the running maximum of the cash ow process by
X
t
sup
st
X
s
11
and let m
2
/2. Over a time interval of length , the probability of
investment is given by [see Harrison (1985), pp.15]:
P
_
X

K
_
= N
_
ln(X
0
/K) + m

_
+
_
K
X
0
_2m

2
N
_
ln(X
0
/K) m

_
where N is the normal cumulative distribution function, K = X

(R) under
the utility maximizing policy, and K = X

(0) under the value maximizing

policy. In the base case environment, the probability of investment over a 5
year horizon is 76% under the value maximizing policy and 70% under the
utility maximizing policy. Thus, risk aversion has a signicant impact on
the likelihood of investment.
This eect is also illustrated by Figure 3 which plots the probabilities of
investment over a ve year horizon as functions of the relative risk aversion
and the cash ow volatility.
Insert Figure 3 here
As shown by the gure, the more uncertain is the environment or the more
risk averse is the decision maker, the bigger is the impact on the probability
of investment.
5 Conclusion
Since the seminal papers by McDonald and Siegel (1986) and Pindyck, the
literature analyzing investment decisions as options on real assets has devel-
oped substantially. In this literature, it is typically assumed that agents are
risk neutral or that markets are complete, so that decisions are made in a
preference-free environment. Yet, in most situations, managers face incom-
plete markets either because the cash ows from the rms projects are not
spanned by those of existing assets or because of compensations packages
that restrict their portfolios. In this paper we propose a simple model which
generalize the real option approach to include risk aversion. We demonstrate
12
that risk aversion provides an incentive for decision makers to further delay
investment. As shown in the paper, this incentive to invest late signicantly
reduces the probability of investment over a given horizon and erodes the
value of investment projects.
Appendix
A. Real options with risk neutrality
Assume that the decision maker is risk neutral and that the subjective dis-
count rate satises = r > . In that case, the objective of the decision
maker is to select the investment time that solves the following problem:
F(x) = sup
S
E
x
_
_

e
rs
(X
s
rI) ds
_
Denote by S(x) the present value of an perpetual cash ow steam X

rI
starting at time zero with X
0
= x. We have
S(x) = E
x
_
_

0
e
rs
(X
s
rI) ds
_
=
x
r
I.
Using the strong Markov property of the cash ow process and the law of
iterated expectations, we can write
F(x) = sup
S
E
x
_
e
r
S(X

.
In this optimization problem the current cash ow is a sucient statistic
for the investment surplus and this surplus is increasing in X. Thus the
optimal investment policy can be described by the rst passage

y
inf
_
t 0 : X
t
y
_
13
of the state variable to a constant threshold y. It is a well known result that
[see Karatzas and Shreve (1999), pp.63]:
E
x
_
e
r
y

=
_
min{x, y}
y
_

.
Hence we nally have:
F(x) = max
yx
_
E
x
_
e
r
y

S(X

y
)
_
= max
yx
_
_
x
y
_

S(y)
_
.
Since r > we have that > 1 and it follows that this optimization problem
can be solved using a rst order condition. The solution is reported in the
main text.
B. Real options with risk aversion
Assume that the decision maker is risk averse and denote his subjective
discount rate by > . In that case, the objective of the decision maker is
to select the investment time that solves the following problem:
F(x) = sup
S
E
x
_
_

e
s
(U (X
t
) U(rI))ds
_
.
Denote by V (x) the present value of an innite of a cash ow steam

U(X
t
)
starting at time zero with X
0
= x. Using the fact that the cash ow process
is a geometric Brownian motion we obtain [see Theorem 9.18 pp.146 in
Karatzas and Shreve (1999)]:
V (x) = E
x
_
_

0
e
s

U(X
s
)ds
_
=
2

2
( )
_
x

_
x
0
s
1

U(s)ds + x

_

x
s
1

U(s)ds
_
.
where and are the positive and negative roots of the quadratic equation
1
2

2
( 1) + = 0.
14
As in the risk-neutral case, the current cash ow is a sucient statistic for
the investment surplus and this surplus is increasing in X. Thus, the utility
maximizing investment policy can be described by a rst passage time of
the cash ow process to a constant threshold. Combining this observation
with the strong Markov property of the cash ow process, we can write
F(x) = max
yx
_
E
x
_
e

V (X

y
)
_
= max
yx
_
_
x
y
_

V (y)
_
.
Since > we have that > 1 and it follows that this optimization problem
can be solved using a rst order condition. The solution is reported in the
main text.
15
References
Dixit, A. and R. Pindyck, 1994, Investment Under Uncertainty, Princeton,
NJ: Princeton University Press.
Harrison, M., 1985, Brownian Motion and Stochastic Flow Systems, New
York: Wiley.
Karatzas, I. and S. Shreve, 1999, Methods of Mathematical Finance, Springer
Verlag: New York.
Kole, S., 1997, The Complexity of Compensation Contracts, Journal of
Financial Economics 43, 79-104.
McDonald, R., and D. Siegel, 1986, The Value of Waiting to Invest,
Quarterly Journal of Economics 101, 707-728.
Moel, A., and P. Tufano, 2002, When Are Real Options Exercised? An
Empirical Investigation of Mine Closings, Review of Financial Studies
15, 35-64.
Pindyck, R., 1988, Irreversible Investment, Capacity Choice, and the
Value of the Firm, American Economic Review 78, 969-985.
16
Parameter Symbol Value
Risk free rate r 20%
Growth rate 10%
Volatility 20%
Investment cost I 1
Initial cash ow X
0
0.875
Discount rate 20%
Relative risk aversion R 3
Table 1: Parameter values
Figure 1: Investment threshold
1.15
1.2
1.25
1.3
1.35
1.4
1.45
1.5
0 1 2 3 4 5 6
I
n
v
e
s
t
m
e
n
t
t
h
r
e
s
h
o
l
d
Risk aversion
(a)
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
15 20 25 30
I
n
v
e
s
t
m
e
n
t
t
h
r
e
s
h
o
l
d
Volatility (%)
(b)
Notes: This gure plots the optimal investment threshold as a function of the
decision makers relative risk aversion (panel (a)) and the volatility of cash
ows (panel (b)). The dashed curve corresponds to the value maximizing
policy while the solid curve corresponds to the utility maximizing policy.
17
Figure 2: Relative change in rm value
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6
R
e
d
u
c
t
i
o
n
i
n
v
a
l
u
e
(
%
)
Risk aversion
(a)
0
2
4
6
8
10
12
14
16
15 20 25 30
R
e
d
u
c
t
i
o
n
i
n
v
a
l
u
e
(
%
)
Volatility (%)
(b)
Notes: This gure plots the reduction in rm value due to risk aversion as a
function of the decision makers relative risk aversion parameter (panel (a))
and the volatility of cash ows (panel (b)).
18
Figure 3: Likelihood of investment
0.45
0.5
0.55
0.6
0.65
0.7
0.75
0.8
0 1 2 3 4 5 6
P
r
o
b
a
b
i
l
i
t
y
Risk aversion
(a)
0.35
0.4
0.45
0.5
0.55
0.6
0.65
0.7
0.75
0.8
0.85
15 20 25 30
P
r
o
b
a
b
i
l
i
t
y
Volatility (%)
(b)
Notes: This gure plots the probability of investment over a ve year horizon
as a function of the decision makers relative risk aversion (panel (a)) and the
volatility of cash ows (panel (b)). The dashed curve is associated with the
value maximizing policy while the solid curve is associated with the utility
maximizing policy.
19