Real Options and Risk Aversion

In the standard real options approach to investment under uncertainty, agents formulate optimal policies under the assumptions of risk neutrality or perfect capital markets. Although the assumptions of risk neutrality or market completeness are crucial to the implications of the approach, they are not particularly relevant to most real-world environments where agents face incomplete markets. In this paper we extend the real options approach to incorporate risk aversion for a general class of utility functions. We show that risk aversion increases the option value of waiting and leads to a significant erosion in project values.