Irreversible investment under interest rate variability : new results

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Title: Irreversible investment under interest rate variability : new results
ISBN: 952-462-096-0
Author: Alvarez, Luis H. R. ; Koskela, Erkki
Organization: Suomen Pankki
Series: Suomen Pankin keskustelualoitteita
ISSN: 0785-3572
Series year: 2003
Series number: 29/2003
Year of publication: 2003
Publication date: 12.11.2003
Published in: Published in Journal of Business, 79, 2, March 2006: 623-644
Pages: 27 s.
Keywords: investoinnit; korot; epävarmuus;
JEL: Q23; G31; C61; J15
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. Key words: irreversible investment, variable interest rates, free boundary problems JEL classification numbers: Q23, G31, C61 AMS classification numbers: 91B76, 49K15, 49J15

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