Utility based pricing and exercising of real options under geometric mean reversion and risk aversion toward idiosyncratic risk (Q1006557)

The authors are dealing with a real options approach. Here, a financial manager faces the decision if and when to invest into a financial project. In contrast to the well-known theory of options on stocks, it is generally assumed that the underlying assets of real options are not traded on relatively liquid markets and furthermore that investment decisions are irreversible. In the present article two lines of existing research are recombined. This is concerning \textit{V. Henderson}'s research on the geometric Brownian motion case [Math. Finance 12, No. 4, 351--373 (2002; Zbl 1049.91072); \url{http://papers.ssrn. com/sol3/papers.cfm?abstract\(_-\)id=569865} (2006)] on one side and, e.g., \textit{A. Dixit} and \textit{R. Pindyck} [Investment under uncertainty. Princeton University Press (1994)] who postulate mean reverting processes as benchmark models for real option analysis, but do not take risk averseness toward idiosyncratic risk into account. In Section 2, the authors of the present paper set their model and specify the investment problem. Using classical Hamilton-Jacobi-Bellman theory and following Henderson's utility based pricing methodology, explicit solutions for this problem are derived in Section 3. In Section 4 the results obtained are compared with Henderson's result for the geometric Brownian motion case. Section 5 contains a comparative static analysis emphasizing the characteristic features of the model.