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Testing the Option Value Theory of Irreversible Investment
Author(s) -
Harchaoui Tarek M.,
Lasserre Pierre
Publication year - 2001
Publication title -
international economic review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 2.658
H-Index - 86
eISSN - 1468-2354
pISSN - 0020-6598
DOI - 10.1111/1468-2354.00104
Subject(s) - economics , geometric brownian motion , valuation (finance) , investment (military) , option value , econometrics , value (mathematics) , microeconomics , financial economics , mathematical economics , mathematics , finance , economy , diffusion process , statistics , politics , political science , law , incentive , service (business)
This article statistically tests the option theory of irreversible investment. Using contingent claims valuation, we derive the value of options to invest in capacity, where the projects are endogenous to the economic circumstances prevailing at the investment date. We then test whether decisions made by Canadian copper mines are compatible with the trigger price implied by the theory. Our model explains investment size and timing satisfactorily from a statistical and an economic point of view; simulations with a mean‐reverting process suggest that the results do not depend crucially on the assumption that price follows a geometric Brownian motion.