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RFS Advance Access originally published online on January 29, 2007
Review of Financial Studies 2007 20(5):1461-1502; doi:10.1093/revfin/hhm013
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Copyright © The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies.

An Equilibrium Model of Investment Under Uncertainty

Robert Novy-Marx
University of Chicago

Address correspondence to Robert Novy-Marx, Graduate School of Business, University of Chicago, 5807 S Woodlawn Ave, Chicago IL, 60637, or e-mail: rnm{at}ChicagoGSB.edu

JEL: G12, E22, R14


  Abstract

We analyze the optimal investment decisions of heterogeneous firms in a competitive, uncertain environment, characterizing firms' investment strategies explicitly and deriving closed-form solutions for firm value. Real option premia remain significant, and are even unmitigated relative to the standard partial-equilibrium model when both are calibrated to observables. Firms consequently delay investment, choosing not to undertake some positive NPV projects. We compare competitive behavior to that of a strategic monopolist, and quantify the welfare loss associated with monopoly. Finally, the model predicts business cycle dependence on firm returns, with returns negatively skewed during industry expansions but positively skewed in industry recessions.

I would like to thank Bob Anderson, Jonathan Berk, Jason Chen, Madhur Duggar, Janice Eberly, Steve Evans, Rob Gertner, Milena Novy-Marx, John Quigley, Mark Rubinstein, Jacob Sagi and Nancy Wallace for discussions and comments. All errors are mine alone.


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