Real Options and Threshold Strategies

TL;DR

This paper analyzes an investment timing problem using diffusion processes, establishing conditions for threshold strategies to be optimal and linking the problem to free-boundary problems in real options theory.

Contribution

It provides necessary and sufficient conditions for threshold strategies to be optimal in investment timing modeled by diffusion processes.

Findings

Threshold strategies can be optimal under specific conditions.

The paper connects investment timing solutions to free-boundary problems.

Conditions for the optimality of threshold strategies are characterized.

Abstract

The paper considers an investment timing problem appearing in real options theory. Present values from an investment project are modeled by general diffusion process. We prove necessary and sufficient conditions under which an optimal investment time is induced by threshold strategy. We study also the conditions of optimality of threshold strategy (over all threshold strategies) and discuss the connection between solutions to investment timing problem and to free-boundary problem.