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Journal of Economics

, Volume 110, Issue 1, pp 5–23 | Cite as

Irreversible exit decisions under mean-reverting uncertainty

  • Andrianos E. Tsekrekos
Article

Abstract

Although many economic variables of interest exhibit a tendency to revert to long-run levels, mean reverting processes are rarely used in investment and disinvestment models in the literature. Previous work by Sarkar (J Econ Dyn Control 28(2):377–396, 2003), that focuses on irreversible entry decisions, showed that mean reversion has three effects on investment: (a) the “variance effect” (mean reversion reduces the long-run uncertainty and thus brings closer the critical investment level), (b) the “realized price effect” (the lower variance resulting from mean reversion makes it less likely to reach extreme high or low price levels, thereby reducing the likelihood of reaching the investment trigger) and (c) the “risk discounting effect” (mean reversion lowers the required rate of return, which affects both the project value and the value of the real option to invest). Metcalf and Hassett (J Econ Dyn Control 19(8):1471–1488, 1995) and Sarkar (J Econ Dyn Control 28(2):377–396, 2003) showed that (a) and (b) work in opposite directions, essentially canceling each other out, however the effect of (c) depends on parameter values, making the overall effect (a–c) of mean reversion on entry decisions ambiguous and parameter-dependent. In this paper, we show that as far as irreversible exit decisions are concerned, the effect of mean reversion is negative: Mean reversion unambiguously lowers the rate of irreversible disinvestment/exit for reasonable parameter values, since the mean reversion in this case only affects the value of the real option to exit and not the value resulting from (real) option exercise.

Keywords

Investment Uncertainty Real options Mean reversion 

JEL Classification

C61 E22 

Notes

Acknowledgments

This paper has greatly benefited from the valuable comments and suggestions made by the participants of the international workshop on “The Economics of Irreversible Choices” that was organized by the Lombardy Advanced School of Economic Research (LASER) and the DEFAP Graduate Business School in Public Economics and was hosted by the Università degli Studi di Brescia in Italy. Special thanks are due to David Schüller who acted as the discussant of the paper at the workshop, as well as to the organizers Giacomo Corneo, Luca Di Corato, Michele Moretto, Paolo Panteghini, Carlo Scarpa and last but not least Sergio Vergalli.

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Copyright information

© Springer-Verlag Wien 2013

Authors and Affiliations

  1. 1.Department of Accounting and FinanceAthens University of Economics and Business (AUEB)AthensGreece

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