The effect of mean reversion on investment under uncertainty

✍ Scribed by Sudipto Sarkar

• Publisher: Elsevier Science
• Year: 2003
• Tongue: English
• Weight: 292 KB
• Volume: 28
• Category: Article
• ISSN: 0165-1889
• DOI: 10.1016/s0165-1889(02)00181-1

✦ Synopsis

Mean-Reverting processes are appropriate for most "real option" investment models, yet Geometric Brownian Motion (GBM) processes are generally used for tractability. Hassett and Metcalf (J. Econom. Dyn. Control 19 (1995) 1471-1488) argue that using a GBM process is justiÿed because mean-reversion has two opposing e ects-it brings the investment trigger closer, and also reduces the conditional volatility (thereby lowering the likelihood of reaching the trigger)and the overall e ect on investment should be negligible for most reasonable parameter values. This paper extends the Hassett and Metcalf model by incorporating a third factor, the e ect of mean-reversion on systematic risk. The main result is that mean reversion, in general, does have a signiÿcant impact on investment. Moreover, this e ect could be either positive or negative, depending on various factors such as project duration, cost of investing, interest rate, etc. Thus it is generally inappropriate to use the GBM process to approximate a mean-reverting process.