SIMPLE APPROACH FOR DECIDING: The Interest Rate Option 5


The constant certainty equivalent assumption is also a standard, if implicit, assumption in many applications in the real options literature. For example, in their analysis of the same option Ingersoll and Ross (1992) impose the far more restrictive assumption of riskless cash flows. Furthermore, the single period CAPM pricing relation is often used, in this literature, to specify the risk premium. To apply this single period result in a multiperiod setting an auxiliary assumption is required to ensure that risk premia are constant.

In spite of the widespread use of the constant certainty equivalent assumption, its restrictiveness undoubtedly limits the applicability of this paper. However, it is worth noting that this assumption nevertheless provides a theory — the simple NPV rule — that is the de facto standard for making corporate financing decisions. Presumably, this is because the theory works better than any other theory. This paper further refines this theory by presenting a simple method for managers to explicitly take into account the option to delay.

Want to get cash in your hands fast and without worrying about too much stuff at the same time? Just like payday loans speedy cash, loans at read only are funded directly and you get the money without any unnecessary waiting. Let us make your financial troubles go away, this is something we are very good at.
The fact that Proposition 2.1 identifies an observable threshold rate means that the theory is testable. It is therefore possible to determine, empirically, the importance of the assumptions that underly the results. Although it has long been recognized that changes in interest rates should affect investment, designing a test based on this relation has been hampered by the fact that the relation between non-callable rates and investment is ambiguous. As Ingersoll and Ross (1992) demonstrate, a decrease in non-callable rates can either increase or decrease investment because although such a decrease increases the present value of future cash flows it also decreases the cost of waiting. No such ambiguity exists when callable rates are used. Ceteris paribus, a drop in mortgage rates unambiguously decreases the hurdle rate and so should increase investment.

The above analysis could also be used to gauge the likely effect of a change in monetary policy. Assume a central bank lowered interest rates for the purpose of stimulating investment. As many researchers have pointed out, in the case of investments which can be delayed such a change could have the opposite effect, not only for the aforementioned reason, but also because the change itself might increase uncertainty about future monetary policy which provides a further incentive to delay investment. Callable interest rates provide an unambiguous answer to what the theoretical effect of the policy change will be — if mortgage interest rates react to the change by decreasing, the policy will have the intended effect, otherwise it will not.

Tags: , ,