A Bayesian Approach to Real Options: The Case of Distinguishing between Temporary and Permanent Shocks

Authors


  • Grenadier and Malenko are at the Graduate School of Business, Stanford University. We thank Geert Bekaert, Jonathan Berk, Thomas Chemmanur, Barney Hartman-Glaser, Campbell Harvey (the Editor), Nadya Malenko, Robert McDonald, Paul Pfleiderer, Lukas Schmid, Ilya Strebulaev, Neng Wang, Jeffrey Zwiebel, the anonymous Associate Editor, two anonymous referees, seminar participants at BYU Marriott School and Stanford GSB, and participants at the UNC/Duke 2008 Corporate Finance Conference, 2008 EFA Meeting in Athens and the 8th Doctoral Conference at LBS for their helpful comments.

ABSTRACT

Traditional real options models demonstrate the importance of the “option to wait” due to uncertainty over future shocks to project cash flows. However, there is often another important source of uncertainty: uncertainty over the permanence of past shocks. Adding Bayesian uncertainty over the permanence of past shocks augments the traditional option to wait with an additional “option to learn.” The implied investment behavior differs significantly from that in standard models. For example, investment may occur at a time of stable or decreasing cash flows, respond sluggishly to cash flow shocks, and depend on the timing of project cash flows.

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