Optimal Investment with Time-Varying Transition Probabilities for Regime Switching

In this paper we generalize the following result of McDonald and Siegel (1986) on optimal investment: it is optimal for an investor to invest when project cash flows exceed a certain threshold. We have other results that refine or extend the result of McDonald and Siegel (1986) by integrating timing flexibility and changes in cash flows with time-varying transition probabilities for regime switching. We emphasize that optimal thresholds are either overvalued or undervalued in the absence of time-varying transition probabilities. Accordingly, the stochastic nature of transition probabilities plays important roles in searching for optimal timing of investment