Investment under Uncertainty and Incomplete Markets

In the standard real options approach to investment under uncertainty, agents formulate optimal policies under the assumptions of risk neutrality or perfect capital markets. However in most situations, corporate executives face incomplete markets either because they receive compensation packages that restrict their portfolios or because cash flows from the firm's investment opportunities are not spanned by those of existing assets. The present paper examines the impact of managerial risk aversion on investment decisions when the manager is exposed to idiosyncratic risk. In the paper, the investment policy selected by the manager reflects a trade-off between his incentives to reduce risk and the need to ensure sufficient efficiency to prevent control challenges. The analysis demonstrates that risk aversion induces the manager to speed up investment, leading to a significant erosion of the value of the option to wait and to investment near the zero net present value threshold.