The Investment-Uncertainty Relationship in a Real Option Model

This paper examines the effect of uncertainty on investment in a real option model. By introducing the contingent claims analysis the opportunity to invest is modeled as an American call option with expiring time. By the use of penalty function, the American option model can rationally analyze the uncertainty-investment relationship. We show that the optimal exercise boundary exhibits a U-shaped pattern against the volatility of the project. Furthermore, such a pattern is inherited by the expected time to exercise the investment option.