Risk Aversion and Real Options
In the standard real options approach to investment under uncertainty, agents formulate optimal policies under the assumptions of risk neutrality or complete financial markets. Although these assumptions are crucial to the implications of the approach, they are not particularly relevant to most real world environments where agents face incomplete markets and are exposed to undiversifiable risks. In this chapter we extend the real options approach to incorporate risk aversion for a general class of utility functions. We show that risk aversion provides an incentive for the investor to delay investment and leads to a significant erosion in project values.