Research Discussion Papers, Bank of Finland
Luis H.R. Alvarez and Erkki Koskela
Irreversible investment under interest rate variability: new results
Abstract: The current literature on irreversible investment
decisions usually makes the assumption of a constant interest rate. We
study the impact of interest rate and revenue variability on the decision
to carry out an irreversible investment project. Given the generality of
the valuation problem considered, we first provide a thorough mathematical
characterization of the two-dimensional optimal stopping problem and
develop some new results. We establish that interest rate variability has a
profound decelerating or accelerating impact on investment demand depending
on whether the current interest rate is below or above the long run steady
state interest rate, and that its quantitative size may be very large.
Allowing for interest rate uncertainty is shown to decelerate rational
investment demand by raising both the required exercise premium of the
irreversible investment opportunity and the value of waiting. Finally, we
demonstrate that increased revenue volatility strengthens the negative
impact of interest rate uncertainty and vice versa.
Keywords: irreversible investment; variable interest rates; free boundary problems; (follow links to similar papers)
JEL-Codes: C61; G31; Q23; (follow links to similar papers)
32 pages, November 12, 2003
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