QEM Master Thesis

Master Thesis
On Insurable Irreversible
Investments under Ambiguity
Author:
Lazar Obradovic
lazar.obradovic@gmail.com
Supervisor:
Prof. Frank Riedel
friedel@uni-bielefeld.de
Master Erasmus Mundus

QEM - Models and Methods of Quantitative Economics
Bielefeld University
July 1, 2011
On Insurable Irreversible Investments under Ambiguity
Contents
1 Introduction
2 Irreversible Investment
2.1 Introduction . . . . . . . . . . . . .
2.2 Simple Example . . . . . . . . . .
2.3 General Model: Set up . . . . . . .
2.4 Relevant Optimal Stopping Results
2.4.1 General Case . . . . . . . .
2.4.2 Case with Diffusions . . . .
2.5 General Model: Results . . . . . .
2.6 Conclusion . . . . . . . . . . . . .
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3 Optimal Stopping under Ambiguity

3.1 Introduction . . . . . . . . . . . . . .
3.2 Ambiguity Model -ignorance . . . .
3.3 Optimal Stopping under -ignorance
3.4 Optimal Stopping under -ignorance:
3.5 Infinite Time Horizon . . . . . . . .
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Case with Diffusions
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4 Irreversible Investment under Ambiguity

4.1 Introduction . . . . . . . . . . . . . . . . .
4.2 Simple Example . . . . . . . . . . . . . .
4.3 Main Results . . . . . . . . . . . . . . . .
4.4 Conclusion . . . . . . . . . . . . . . . . .
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5 Insurable Irreversible Investment

5.1 Introduction . . . . . . . . . . . .
5.2 Non-Ambiguous Case . . . . . .
5.3 Case with Ambiguity . . . . . . .
5.4 Conclusion . . . . . . . . . . . .
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6 Concluding Remarks
36
A Proof of Proposition 5.1
37
B Proof of Proposition 5.2.
40
C Proof of Verification Theorem 2.3
43
Introduction
Investment opportunities arise frequently in the world of economics. Firms purchase of new equipment, building a new factory plant, utilisation of a patent,
hiring and training new workers, are all obvious examples of investment. Somewhat less obviously, closing of the loss-incurring firm is also an investment: by
paying the costs related to closing of the firm it is investing in itself by reducing
its future losses. Even non-economic situations like education and marriage can
be considered as investments. Naturally, every agent with investment decision
seeks for methods of evaluation of the investment opportunity.
Most investment decisions share following three characteristics:
1. Investment cost is (for the most part) irreversible: once the firm decides
to make an investment it incurs a cost that cannot be recovered in case a
firm decides to change its mind. This can happen when investment costs
are industry specific, when the investment turns out to be, ex post, bad,
due to significantly lower prices of used goods;
2. Future rewards from the investment are uncertain: at the moment of investing firm does not know the precise future reward from the investment.
3. Timing matters: there is a time frame frame within which the firm can
make an investment. Waiting for new information to come may be beneficial to investments revenue. For example, a firm about to launch a new
product can wait to see the future market conditions.
Orthodox method for valuing investment opportunity is net-present value
(NPV) which says: invest if the discounted future cash flows arising from investment exceed the investment cost. However, this method neglects several
important features of investments: it assumes that investment can be made
now or never and that the investment costs can be recovered if the investment turns out to be a bad one. This can lead to gross errors, as demonstrated
in a classical text by [Dixit and Pindyck, 1994]. In this work we will present
their framework which will be the basis for the final chapters and the main results of this work.
Essentially, the analysis of valuing of investment opportunity is based on
methods of financial mathematics of valuing financial option. More concretely,
we will see that investment opportunity can be treated as (perpetual) American
call. The main contribution of this work (chapter 5) is to consider portfolio of
options which makes the investment, in a certain sense, insured, and evaluate
it using the same methods. Insurable irreversible investments that will be considered will consist of classical irreversible investment as well as the opposite
option which will make the investment opportunity insured. Interestingly, the
payoff of this kind of real options corresponds to payoff of (perpetual) American
straddle, so all of our analysis readily applies to evaluation of that derivative.
We will model the movement of the value of investment opportunity with
geometric Brownian motion (as in Black-Scholes-Samuelson model of evaluation of financial derivatives). In addition to traditional models of uncertainty
with a unique prior probability measure, we will consider the cases of ambiguity/Knightian uncertainty in the spirit of [Gilboa and Schmeidler, 2004] with
2
multiple priors. More precisely we will model the firms uncertainty about drift
of underlying Brownian motion with ambiguity model of -ignorance as considered in [Chen and Epstein, 2002], [Nishimura and Ozaki, 2007] and [Cheng
and Riedel, 2010]. Our main tool will be the theory of optimal stopping of diffusions. Classical references include [Krylov, 2008] and, more recently, [Peskir
and Shiryaev, 2006]. For the ambiguous setting we use the theory of optimal
stopping under ambiguity as developed in [Cheng and Riedel, 2010].
Chapter 2 considers, in a rigorous manner, the traditional model of irreversible investment under uncertainty as offered in [Dixit and Pindyck, 1994].
A very brief review of relevant optimal stopping results is offered for the purposes of consistency and comparability with the theory of optimal stopping
under ambiguity. Chapter 3 introduces the reader to -ignorance and summarizes the relevant results on optimal stopping under ambiguity by [Cheng and
Riedel, 2010] in the special case of -ignorance. Chapter 4 uses these results to
study the problem of irreversible investment under ignorance. In these three
chapters we have made a sufficient exposition to introduce insurable irreversible
investment opportunities. We do so in chapter 5, and perform the same analysis
as with classical irreversible investment opportunities in both ambiguous and
non-ambiguous setting. Final chapter offers some ideas about future research
and concludes the work.
2
2.1
Irreversible Investment
Introduction
Having in mind the characteristics of investment opportunities (listed in previous chapter) we see that when a firm decides to make the investment it gives
up the option of waiting for the new information to arrive. Therefore there is
an opportunity cost related to every investment which needs to be taken into
account when investment decision arises. Theory of irreversible investment, as
presented in [Dixit and Pindyck, 1994] does precisely that, and we will address
it in a rigorous manner in this chapter.
Before proceeding, we note here a relationship between irreversible investment and finance. A firm that has to make an investment decision can be
considered a holder of an option to invest. When option is exercised an investment expenditure is made and a future payoff of the project is received. Thus,
we can interpret the investment decision of the firm as an (perpetual) American
call option with a strike price equal to the investment cost, and a spot price
equal to the value of the project at the time of investment. This interpretation
allows us to use tools of valuation of financial options to the valuation of investment opportunities.
This chapter is organized as follows: in section 2.1 we give a very simple
example that illustrates the model that we are about to develop. In section
2.2 general model of irreversible investment is presented, following chapter 4 of
[Dixit and Pindyck, 1994]. There the model is presented on a somewhat intuitive level; here we give a more rigorous mathematical foundation and relate
it to optimal stopping theory. In section 2.3 we present the results in optimal
stoppping in continuous time that are relevant for our analisys. Due to the space
constraints, we do not offer the full proofs of the results, but when possible we
give some intuition behind them. In section 2.4 we solve the model and discuss
it a bit further, while section 2.5 concludes the chapter.
2.2
Simple Example
Here we present a simple example that is a useful starting point in developing of

the more general model. It develops the idea of timing of irreversible investment
of a firm facing uncertainty in a simple, two state two period model. In chapter
3, this example will come in very handy as a starting point for introduction
of ambiguity. This example is essentially the example of a widget factory in
chapter 2 of [Dixit and Pindyck, 1994], but we present it here in a more rigorous
language as found in [Nishimura and Ozaki, 2007]
We suppose a firm has the possibility of making an investment. For example,
a firm has the possibility to buy a patent and spend a significant amount of
money to utilize it. We suppose that the investment is irreversible and that the
investment cost is sunk. We denote the investment cost by I.
Suppose that there are two periods, 1 and 2, and let us denote the operating
profits of those two periods with 1 and 2 respectively. We suppose that there
is no uncertainty in period 1, so 1 can assume only one value. However, there is
uncertainty in period 2 over two possible states of the world: boom (b) and slump
(s). If the state of the world in period 2 is boom, which represents favourable
market condition with respect to investment, the firms operating profit will be
2 = b > I. On the other hand, if the state of the world in period 2 is slump, i.e.
if market conditions are unfavourable with respect to the investment, the firms
operation profit will be 2 = s < I. Suppose that r is a given discount rate.
Let pb be the probability that boom occurs in second period, and ps = 1 pb
the probability that slump occurs. Given all these information the firm has to
decide whether to invest and, if yes, whether to do it in period 1 or period 2.
If the firm decides to invest in period 1 it will earn 1 I in period 0. The
1
(pb b + (1
value of expected discounted profit in period 2 is given by: 1+r
pb )s ). Summing the two profits up we obtain the following value of expected
discounted cash flow when firm invests in the first period:
1
(pb b + (1 pb )s )
(2.1)
1+r
We note that traditional NPV rule stated that the firm should invest if the
above expression is positive.
If the firm decides to invest in period 1 there will be no profits from period
0. Further more, firm will only invest if the period is boom, so the expected
discounted cash flow will be:
1 I +
pb
(b I).
(2.2)
1+r
Here we note that, in case of boom, firms profit flow in period 2 is positive
due to b > I.
By comparing the last two equations firm can decide whether to postpone
the investment decision or not. Namely, if discounted value of cash flow when
investing in the second period exceeds that of investing in first period then the
firm does not invest in the first period. This means that postponement criterion
is given with the following inequality:
pb
1
(b I) > 0 I +
(pb b + (1 pb )s )
(2.3)
1+r
1+r
Of course, firm invests during the first period if the opposite inequality is
true. If we compare this to the traditional NPV rule we see that it can happen
that expression 2.1 is positive, but postponement criterion 2.3 is also satisfied,
so the firm postpones its investment in spite of positive NPV. A numerical
example illustrating this fact is available in chapter 2 of [Dixit and Pindyck,
1994].
At the very end of this section we comment on the influence of level of risk
to the postponement decision. For simplicity, we suppose that pb = 0.5. Now,
increase in risk could be characterized by a mean preserving spread of payoffs in
second period: instead of b we have b + in case of boom, and, similarly, s
in case of slump, where is a positive constant. We can see that this means that
preserving spread decreases the value of the right hand side in postponement
criterion 2.3 and thus makes the waiting more likely. Economic explanation
can be as follows: with the increase in risk the potential profit of investing in
second period increases while no additional loss is incurred (in slump we get 0
no matter what the payoff is). This makes the waiting more appealing.
2.3
General Model: Set up
In this section we present the basic model of irreversible investment under uncertainty in continuous time. This model was originally developed in [McDonald
and Siegel, 1986] and is presented, in a simplified form, in chapter 4 of [Dixit
and Pindyck, 1994]. Here we follow the approach of latter adding necessary
mathematical rigour.
Suppose that within a time frame [0, T] a firm can invest in a project whose
value at the time t [0, T] is given by Wt . We can think of the value of the
project as aggregate expected profit generated by the project calculated at time
t or, more simply, a total expected revenue calculated in todays money. We
suppose the value of the project at the time 0 is known and we denote it with
W0 = x R. At any point in time the firm can decide to invest in the project.
We suppose that the investment cost I R is constant over time. If the firm
invests at time t it receives a payoff of ert (Wt I) where r R is a given
discount rate1 . The problem is to determine the best time for a firm to make
an investment.
We now impose some mathematical conditions to our model. Let (, F, P )
be a given probability space with B = (Bt )t0 a one-dimensional2 Brownian
motion. Let (Ft )t0 denote a filtration generated by B and augmented by P .
We suppose that value process Wt is a geometric Brownian motion:
Z t
Z t
Wtx = x +
Wt dt +
Wt dBt ,
(2.4)
0
where R and R are two constants. Further properties of these two

constants will be analysed bellow3 .
Before we proceed we pause to comment on the strength of the above assumption. Obviously, the geometric Brownian motion assumption is not very
realistic. However, working under this assumption gives us a very convenient
framework and allows us to develop the ideas and obtain basic results which
can serve as a basis for more general models.
Let T0T denote the set of all stopping times over interval [0, T]. The problem of choosing the best time to invest can now be stated more formally as the
following optimal stopping problem:
V (t, Wt ) = sup er (W I)
(2.5)
Tt
2.4
Relevant Optimal Stopping Results
Before tackling the problem above we present several well known results from
the classical theory of optimal stopping which we will use in later text. The
1 We assume that a discount rate is exogenously given. If we would assume some kind of
complete market condition r would correspond to a riskless interest rate. Since it is not the
main focus of this work, nor does it affect the results, we do not do that here. Thus, as long
as we keep the previous remark in mind, we can even interpret r as a subjective discount rate.
2 Throughout this work we stay in one-dimensional case, but generalization to multiple
dimensions is possible and straightforward.
3 As a reminder, we state here that the solution of the above GBM is given with

2
)t + Bt
Wtx = x exp (
2
.
purpose of this is twofold. First, it makes the exposition clearer and, somewhat,
self-contained. Second, it allows for direct comparison with results in optimal
stopping under ambiguity which will be presented in the next chapter.
Very accessible introduction to optimal stopping (as a special case of stochastic control) based on viscosity solutions of PDEs with financial applications in
mind is available in [Pham, 2009]. The monogoraph [Peskir and Shiryaev, 2006]
on optimal stopping presents more general results in great detail with various
examples of applications thoroughly worked out. The setting of our consideration of optimal stopping of diffusions resembles the most the on found in classic
text [Krylov, 2008].
2.4.1
General Case
Let, as above, (, F, P ) be a given probability space with B = (Bt )t0 a onedimensional Brownian motion and (Ft )t0 filtration generated by B and augmented by P . Let [0, T ] be a given time frame where T is a finite positive real
number.
Let X = (Xt )t[0,T ] be a given adapted process. We interpret X as a gain
process. That is, we suppose there is an agent who observes the values of X in
time and can choose to stop at any time t [0, T ] and receive a payoff Xt . We
assume that process X satisfies the following assumption:
E[ sup |Xt |] <
(2.6)
t[0,T ]
We are interested in finding the best time to stop. This means we are looking
for stopping time4 that maximizes the expected payoff. Formally, given the
value process V :
Vt = sup E[X ],
(2.7)
T ([t,T ])
where T (t, T ) denotes the set of all stopping times such that t T , we are
looking for a stopping time such thath VtT = E[X ]. If it exists, we call
the optimal stopping time.
We introduce now the concept of essential supremum which will be used
throughout the text. The reason it is being introduced is the following: the right
hand side of the equation (2.7) needs not be a measurable function (since the
supremum is taken over uncountable set of indexes), and behaviour of process X
on some null sets can affect the value of V undesirably. Essential supremum is a
measurable function that can, in a certain sense, be used instead of supremum
where needed.
Theorem 2.1 (Essential Supremum). Let {Z : I} be a family of random
variables such defined on (, F, P ) where the index set I can be arbitrary. Then
there exist a countable subset J of I such that the random variable Z : R
defined by
Z = sup Z
(2.8)
J
satisfies the following two properties:

4A
stopping time : [0, T ] [0, T ] is a process satisfying (t [0, T ]) < t Ft

and < P -almost surely. Stopping time formalizes the concept of random time where
the randomization is performed only using the available information
1. For each I we have P (Z Z ) = 1.

2. If Zb : R is another random variable satisfying the previous property,
b = 1.
then P (Z Z)
Moreover, if the family {Z : I} is upwards directed5 then the countable
set J = {n : n N} can be chosen so that
Z = lim Zn P-a.s.
n
(2.9)
where Z1 Z2 . . . P-a.s.
We call the variable Z the essential supremum of the set {Z : I}
and use the following notation ess supI Z := Z . The above formulation is
a Lemma 1.3 from Peskir and Shiryaev [2006] where a detailed proof can be
found.
With essential supremum at our disposal, the existence of optimal stopping
time can be proven under mild assumptions. Suppose that the following holds:
E[
|X |] <
sup
(2.10)
T ([t,T ])
We define:
St := ess sup E[X |Ft ]
(2.11)
T ([t,T ])
The process S = (St )t[0,T ] is often refered to as a Snell envelope of X.

We define a stopping time t as follows:
t = inf {s t : Xs = Ss }.
(2.12)
Since St Gs (by definition of essential supremum), stopping time t tells us

to stop the first time the process we are observing becomes equal to its Snell
envelope. It will turn out that this stopping time is in fact optimal, as the
following result shows.
Theorem 2.2. Suppose that problem is defined as above ( (2.7)) and that assumption (2.10) is satisfied. Assume also that
P (t < ) = 1, t 0.
(2.13)
St E[X |Ft ] for each Tt
(2.14)
St = E[Xt |Ft ]
(2.15)
Then for all t 0 we have:
where Tt denotes the set of all stopping times satisfying > t. Moreover, if
t 0 is given and fixed then we have:
1. The stopping time t is optimal in (2.7)
2. If is an optimal stopping time in (2.7) then t P-a.s.
5 Collection {Z
: I} is upwards directed iff for any and in I there exists a in I
such that Z Z Z P-a.s.
3. The process (Ss )st is a smallest right-continous supermartingale which

dominates (Xs )st .
4. The stopped process (Sst ) is a right continous martingale.
Finally, if condition (2.13) does not hold (so P (t = ) = 0), then there is no
optimal stopping time (with probability 1) in (2.7).
The proof of the above classical result is available in Peskir and Shiryaev
[2006], Theorem 2.2. .
2.4.2
Case with Diffusions
Above results on optimal stopping were of general kind: almost no requirements

were placed on the nature of the proces X. By adding some structure to the
problems presented there we will be able to get more powerfull and applicable
results.
We fix a domain G R and we define optimal stopping G as follows:
G = G (y, ) = inf{t > 0 : Wt ()
/ G}
(2.16)
This optimal stopping time is called the first exit time for obvious reasons.
Suppose that W = (Wt )t[0,T ] is a diffusion given with a following stochastic
differential equation (SDE):
Z t
Z t
Wt = x +
(Wt ) dt +
(Wt ) dBt .
(2.17)
0
We assume that the starting point W0 = x R is known.

We also make an important technical assumption under which the uniqueness
of solution of the above SDE is guaranteed. Namely, we assume that functions
(x) (drift coefficient) and (x) (diffusion coefficient) satisfy Lipshitz condition.
That is, there exists a constant D such that:
|(x) (y)| + |(x) (y)| D|x y| ,for all x, y R.
(2.18)
We note here that W satisfies a strong Markov property6 .

In previous section we supposed an agents payoff was given by a random
process X. Here, we suppose that process to be given by a function of diffusion
W . Formally, let f : [0, T ] R R be a continuous function on which we will
impose some additional regularity and smoothness conditions later. Now, we
say that the agent receives a payoff of f (t, Wt ) if he decides to stop at time t.
Because process W satisfies strong Markov property it is not important, in a
certain sense, which value the process took up to time t. This fact allows us to
replace the value process:
Vt = sup E[f (Wx )]
(2.19)
TG,t
6 A proces W satisfies strong Markov property iff for every Borel function f on R and every
stopping time such that < P-a.s we have
E[f (Xx+h )|F ] = E[f (XhX )]
for all h 0.
with a value function v satisfying: Vt = v(t, Wt ). This leap is extremely important in both theory and application and there exists a huge literature on the
value functions of optimal stopping problems. It is not always easy to find the
function v, but some methods have been developed for checking if a function
that we somehow identified as a possible candidate really is a value function.
These methods are summarized in what came to be known as verification theorems and we present on of those here.
We introduce the following differential operator7 :
2 (x) 2
(2.20)
+
x
2 x2
If function f is smooth enough, when solving problems like this a principle of
smooth fit or high contact can be applied. It basically says that, under certain
conditions, if f is continuously differentiable function v is also continuously
differentiable. This principle is very useful in applications but can be difficult
to prove. Nevertheless, it is used in literature even when it was not strictly
proven in order to identify a candidate for solution, and afterwards some kind
of verification method is applied to confirm that the solution coincides with the
candidate.
Following theorem is one of the verifications theorems. Since we could not
locate the similar theorem in the setting of [Krylov, 2008] we present a nonambiguous counterpart of theorem 3.6 in [Cheng and Riedel, 2010]. The proof
is offered in appendix.
L := b(x)
Theorem 2.3. Let f : [0, T ] R R be a continuous function that satisfies a

following growth condition: there exists m N and a constant K > 0 such that:
|f (t, x)| K(1 + |x|)m
Let v : [0, T ] R R be an element of Sobolev space
Hamilton-Jacobi-Bellman equation:
max
(t,x)[0,T ]R
(2.21)
W1,2
that solves the
{f (t, x) v(t, x), vt (t, x) + Lv(t, x)} = 0
(2.22)
and the terminal condition

v(T, x) = f (T, x),
xR
Assume also that v and its generalized first derivatives satisfy a growth condition: for some n N and K > 0 we have:
|v(t, x)| + |vx (t, x)| K(1 + |x|)n
(2.23)
Then v is the value function of our optimal stopping problem, i.e. Vt = v(t, Xt )
A remark about the theorem is in place. The fact that v belong to Sobolev
space W1,2 means that it can, in a certain sense, be well approximated by functions of the space C 1,2 . In our applications we will work with functions that
7 The differential operator presented above is just a one dimensional case of well known
operator L closely related to (multi-dimensional) Ito formula
10
belong to C 1,2 so the issues regarding Sobolev space are not of importance for
now; we merely state the theorem so it is comparable to one offered in [Cheng
and Riedel, 2010]. Further details about the space W1,2 and its usefullness in
our context can be found in [Krylov, 2008] and [Friedman, 1976].
At the end of this review of optimal stopping results we note that all of the
above results can be extended naturally to infinite horizon cas as long as we
consider almost surely finite optimal stopping times.
2.5
General Model: Results
Equipped with appropriate tools we proceed to solving the problem posted in

section 2.3. In order to be able to obtain as explicit solution as possible we
suppose that relations among variables in the finite horizen case converge,
as the horizon goes to infinity, to those in the infinite horizon case8 . This
assumptions is often used in similar problems, and some motivation for it is
give in [Dixit and Pindyck, 1994]. Thus, we can solve the problem posed in
the equation (2.5) using the results from previous section. Results from section
2.4.1 suggest that the optimal stopping problem exist. Having in mind the
verification theorem 2.3, as well as the principle of smooth pasting mentioned
before it, we will try to guess the solution based on intuition, and then we will
use the theorem to prove that the solution we suggested is right.
First of all, it is intuitively clear that it would never be optimal to stop
if drift discount rate is smaller than drift coefficient. This is simply because,
on average, the value of the project will increase much faster than it would be
discounted, so it is always optimal to wait. Formally, let r < . We recall
at at any fixed time
t random variable Bt is normally distributed with mean
0 and variance t. This implies that eBt is log-normally distributed and
2 t
2 t
E[eBt ] = e0+ 2 = e 2 holds. Applying this to Xt , writen as in equation for
solution of geometric Brownian motion (see footnote 3) we can obtain:
h

i
2
E[Wtx ] = E x exp (
)t + Bt = xe
(2.24)
2
Value function is, by definition, greater than payoff received at stopping at
any fixed time t, so using the above equation we obtain:
v(t, x) E[ert (Wtx I)] = ert E[(Wtx )] Iert = xert Iert
(2.25)
Since r < , the right hand side of the above equation goes to infinity we see
that value of our problem is infinity and it is never optimal to stop.
Let now r = . It can be shown that in this case we will v(t, x) = x holds9 .
Intuitive explanation for this would be that the effect of increase of value of
the underlying project is cancelled out by the equal decrease in payoff due to
discounting, and infinite horizon makes the investment cost negligible. Again it
is never optimal to stop since v(t, x) > f (t, x) always holds true.
8 Taken
from [Nishimura and Ozaki, 2007].

of argument from the previous case and application of optimal sampling
theorem. See example in chapter 5 in [Pham, 2009] for more details.
9 Combination
11
Finally, let us now turn to the interesting case where r > . In this case,
intuition suggests that there exists a level W such that it should be optimal to
stop when the value of investment reaches this level, i.e. when Wt > W . So we
suppose that our continuation region is of the form D = [0, W ]. Furthermore,
we guess that the function v is of the form v(t, x) = ert (x) 10 . We will apply
HJB equation to derive the result. We note that, since we are in simple case
with geometric Brownian motion, the differential operator L reads as:
2 x2 2
(2.26)
+
x
2 x2
From our verification theorem and Bellman equation we expect the solution
v(x) to satisfy Lv(x) + vt (x) = 0 in continuation region. This equation, after
cancelling out ert , the is given with:
L = bx
1
r x0 (x) 2 x2 00 (x) = 0,
x < W0
(2.27)
2
The above is a ordinary differential equation. It is a well known homogeneous
linear differential equation with variable coefficients known as Euler-Cauchy
equation. It has a characteristic solution of the form xm . Plugging that into
the above equation we obtain:
1
x < W0
(2.28)
rxm mxm 2 m(m 1)xm = 0,
2
We see that xm is a solution of 2.27 if and only if the following quadratic
equation is satisfied:
1
r m 2 m(m 1) = 0,
2
The solutions of the above equation are:
r
1
= 2 + ( 2 )2 +
2
2
r
1
= 2 ( 2 )2 +
2
2
x < W0
2r
2
2r
2
(2.29)
(2.30)
(2.31)
Obviously, we have > 1 and < 0. Since we have found two characteristic
solutions we know that our function must be a linear combination of them,
as a solution of 2.27. This means that there exist numbers A, B R such that
(x) = Ax + Bx
(2.32)
We proceed by finding values A and B, and W .

First of all, we expect the value function to satisfy condition limx0+ v(x) =
0 because geometric Brownian motion becomes constant (zero) in that case.
This requirement gives us that, because of < 0, B has to be equal to zero.
Indeed, if that was not the case, we would have limx0+ v(x) = .
Remaining two constants will be determined using smooth-fit condition as
follows. From Bellman equation, we expect our value function to be equal to
10 This
is a standard trick when dealing with optimal control of discounted functions.
12
f on stopping region. Thus, we have imposed piecewise conditions on our

functions. But since we expect our function to be smooth we require that in the
critical poing W piece-functions have equal values and first derivatives. That
is, we require following to be satisfied:
v(t, W ) = ert (W I)
vx (W ) = ert
(2.33)
which is equivalent to:

(W ) = W I
0 (W ) = 1
(2.34)
Substituting the last two conditions into 2.32 (with B=0) we obtain, by
direct calculations:
W = I
A=
This means that function v is of the form:

ert ( W Wx ),
v(t, x) =
ert (x I),
(2.35)
(W )1
0 < x < W
W x
(2.36)
and, of course, optimal time is then given by = inf{t | Wt W } = inf{t | f (t, Wt ) =

v(t, Wt )}. This completes the solution of our optimal stopping problem.
2.0
1.5
1.0
0.5
0.5
1.0
1.5
2.0
2.5
3.0
-0.5
-1.0
Figure 1: Value function of irreversible investment problem (full) and payoff

function (dashed).
13
2.6
Conclusion
In previous section we have considered a provblem of irreversible investmenet

under uncertainty and we offered the solution using the theory of optimal stopping of stochastic processes. As a conclusion to this chapter we offer a numerical
example that illustrates the theory presented above.
Following [Dixit and Pindyck, 1994] we take following values of parameters
of our model:
I = 1, = 0, = 0.2, r = 0.04
Plausibility of these values can, to some extent, be justified (see page 153. in
[Dixit and Pindyck, 1994]). If we plug in these values in the formulas we obtained
earlier we would get that W = 2 = 2I and = 2, A = 14 . It is interesting to
see how a value function in this case looks like and how it compares with the
payoff function. This can bee seen in figure 1.
As expected, value function is higher than the payoff function. Value of
boundary W = 2 = 2I is very interesting: it states that it is optimal to
wait much longer (twice as much) as the traditional NPV suggests. This has
simple economic explanation: since the firm invests only if the value of the
project increases then benefits of waiting are greater then losses incurred by
investing too soon. This leads to delay of decision investment. It is important
to understand that in case of increase of risk (that is, increase of volatility )
the value function would be even higher, and the waiting would be postponed
even further as can be seen easily analytically from the expression for .
Finally we note that the function v is smooth everywhere (as we constructed
it) and coincides with the payoff function after value W . In that sense this
represents a nice visualization of HJB equation as well as optimal stopping
problems in general.
14
3
3.1
Optimal Stopping under Ambiguity

Introduction
Up to now, we have (implicitly) assumed that the agent with optimal stopping
problem (investment decision) was perfectly informed about probability distributions over states of the world. This assumption, widely spread over economic
literature, is quite unrealistic. By observing the past events the agent can have
some ideas about the probability distribution, but can hardly know the exact
distribution. Even if we interpret the given probability as a subjective one, the
problems arise, as Ellsberg paradox and similar experiments have shown. Possibly, a more appropriate way to model the situation that the agent is facing
would be with multiple priors, in the spirit of [Gilboa and Schmeidler, 2004].
That is, we can suppose that agent has identified a set of probability measures
(priors) but is unsure of which one is a correct one. Inspite of this, she wants
to find a way to behave optimally. We will examine this approach here in the
setting of optimal stopping.
Problem of optimal stopping with multiple priors in discrete time has been
solved in [Riedel, 2009]. The continuous counterpart of that paper is [Cheng and
Riedel, 2010]. There, the general theory is developed based on g-expectations,
g-(super)martingales and related concepts. The results offered there are general with quite technical proofs that rely heavily on the results related to gexpectation. These in turn exploit the connection of model of ambiguity to
backward stochastic differential equations. Here, we will not go into all the
details of results given in [Cheng and Riedel, 2010]. Rather, we present the
general results (without proofs) and cover in some detail the results related to
mathematical framework of irreversible investment problem.
One of the leading examples of modelling ambiguity with multiple priors is
-ignorance, developed in [Chen and Epstein, 2002]. It is called drift ambiguity in [Riedel, 2009], and special attention has been paid to it. In context of
irreversible investment it has been used in [Nishimura and Ozaki, 2007]. It is
a simple and intuitive framework that offers valuable insights into the nature
of problems under ambiguity. Here we follow their approach: we will focus on
optimal stopping under -ignorance, and especially to the case where payoff
depends on the diffusion.
This chapter is organized as follows. Section 3.2 introduces the reader to
-ignorance and presents the connection with backward stochastic differential
equations (BSDE). Comments about more general models of ambiguity are offered. Section 3.3 presents the results about optimal stopping from [Cheng and
Riedel, 2010] specialized appropriately for -ignorance. Section 3.4 condiers a
special case of optimal stopping under -ignorance when payoff process depends
on diffusions. All the results discussed in sections 3.2 trough 3.4 are considered
in finite time setting; last section of this chapter considers infinite time horizon
and concludes the chapter.
3.2
Ambiguity Model -ignorance
In this section we formally introduce drift ambiguity and we point out to some
of its properties. The presentation here combines relevant parts from [Chen
and Epstein, 2002] and [Cheng and Riedel, 2010].
15
Let (, F, P0 ) be a probability space. Suppose that we are in a finite setting,

that is t [0, T ], T < . As before we suppose that B = (Bt )t[0,T ] is a given
one-dimensional Brownian motion and we let (Ft )t[0,T ] , with FT = F, denote
a filtration generated by B and augmented by P0 .
Let X = (Xt )tT be an adapted, nonnegative process, that has continuous
sample paths. We suppose that X is bounded in L2 (, F, P0 ):
E0 [ sup Xt2 ] < +
(3.1)
t[0,T ]
We suppose that there is an agent who observes the process and chooses
when to stop it. If is an optimal stopping, and agent chooses to stop in accordance with it, her payoff upon stopping will be X .
In later sections of this chapter we will discuss how an agent can choose the
time of stopping optimally. For now, our goal is to introduce the concept of
-ignorance. Hence we assume that we are given a stopping time T0T and
we will explain how agent evaluates her payoff under -ignorance.
We proceed by constructing the set of multiple priors that describes ignorance. Let denote the set of all progressively measurable11 processes.
For a given constant R+ we denote the subset of with processes valued
in [, ] with , i.e. :
:= { | (t [0, T ])
t [, ]}
(3.2)
We see that every member of easily satisfies Novikovs condition12 . This

means that for an arbitrary a proces z defined with
Z
Z t
1 t 2
s ds
s dBs )
zt := exp(
2 0
0
is a martingale with respect to measure P0 . According to Girsanovs theorem
this gives rise to a probability measure P defined with:
Z
P (A) :=
zT dP,
, A F,
A
such that P and P0 are equivalent, and a process B defined with:

Z t
Bt := Bt +
s ds
0
is a standard Brownian motion with respect to P .

Above considerations allow us to introduce a set of probability measures P :
P := {P | }
11 A process is said to be progressively measurable if for every time t [0, T ], the mapping
[0, t]x R defined with (s, w) Xt (w)is B([0, t]) Ft -measurable.
12 A F -adapted, square integrable process is said to satisfies Novikovs condition if
Rt
E[exp( 21 0T (, s)ds] < . It is well known that if a process satisfies this condition then
R
R
Mt := exp( 0t dB 21 0t 2 ds) is a martingale; see for example [ksendal, 2003]
16
Set P represents the set of multiple priors that agent uses in her considerations. when she models ambiguity using -ignorance. In what follows, E P will
denote the expectation with respect to probability measure P .
With set of priors at our disposal, we turn to agents evaluation of X . We
assume that agent does not know the objective probability measure, but knows
that it belongs to a set P . With this knowledge, following [Gilboa and Schmeidler, 2004], she behaves pessimistically and evaluates the payoff of X at time
t [0, T ] with a process:
Et (X ) := ess inf
E P [X |Ft ]
P P
(3.3)
This in particular means that at beginning (t = 0) the payoff is evaluated using

functional: E0 (X ) := inf P P E P [X ].
It has been shown in Chen and Epstein [2002] that process Et satisfies following SDE:
dYt = |Zt |dt + Zt dBt ,
(3.4)
for some unique process Z. The proof offered there covers a slightly more general
case and relies on the existence of solutions of backward stochastic equations
and measurable maximum theorem. We do not offer the proof here, but offer
some simple intuition that should persuade us that the result is correct.
In the nonambiguous case the agent would evaluate his payoff under probability P at time t via following expression:
Yt = E [X |Ft ]
The expression on the right hand side is a martingale. Hence, by a martingale
representation theorem, there exists a (unique) process process Z = (Zt )t[0,T ]
such that:
Z
T
Zt dBt ,
Yt = E[X] +
0
where B is Brownian motion related to P via Girsanov theorem. But, according to Girsanovs theorem, dBt = t dt + dBt , so the above equation can be
rewritten as:
Z t
Z t
Yt = E[X] +
t Zt dt +
Zt dBt
0
The above expression explains why this type of ambiguity is called drift
ambiguty: when varies trough different drift values are assumed so it
effectively represents uncertainty about drift coefficient. It should be intuitively
clear, that the expression on the right-hand side above takes lowest values when
Zt takes lowest values. But was defined so that |t | < . Hence, the lowest
possible values should be |Zt |. This means exactly that SDE 3.4 is satisfied.
General Model of Ambiguity.

There is a more general way to model ambiguity of which -ignorance is just
the case. As we have seen, ignorance makes evaluation of the form Et (X ) :=
ess inf P P E P [X |Ft ], where set P was suitably chosen. More generally, we can
consider evaluating X (as defined above) with processes of the form:
Et (X ) := ess inf E P [X |Ft ] + c(P ),
P P
17
for an appropriately chosen function c that represents cost of using probability

P in evaluation. These kind of processes are called variational preferences and,
under certain circumstances, can be connected to their own BSDEs. Since the
results on optimal stopping under ambiguity in [Cheng and Riedel, 2010] were
delivered withing this framework, we will now summarize the most important
results about that here, with hope that they will offer easier understanding of
the results that we presented in next section.
We keep the already introduced probabilistic setting, we will only redefine
E. In order to do so, we need the following definition.
Definition 3.1. A function g : [0, T ] R R is called a standard driver
for variational expectations if it satisfies the following properties:
RT
1. (g(w, t, z))t[0,T ] is an adapted proces with E0 [ 0 |g(t, z)|2 dt] < + for
all z R
2. g is Lipschitz continuous in z, and uniformly continuous in t and w.
3. g(w, t, 0) = 0 for all t 0 and
4. g is concave in z.
We will use a standard driver for variational expectations to define precisely a
variational expectation: we will give the explicit form of a set P and of a penalty
function c. We take this approach because, thanks to the fact that function g
has nice properties, it will be possible to represent variational expectations as a
solution of a BSDE. This presents a powerful tool in applications.
Let g be a standard driver. We define f : [0, T ] R, a convex dual of g,
as follows:
f (w, t, ) := sup g(w, t, z) z
zR
Let D be a set of all progressively measurable process processes = (t ) such
that
Z T
E0
f (s, s )2 ds <
0
Each process of D represents a Girsanov kernel and defines a probability

measure P equivalent to P0 13 . Penalty function ct,T (), represents a cost of
using the measure induced by at time t. We define a penalty function c as
follows:
Z
T
ct,T () = E [
f (s, s )2 ds|Ft ]
Finally we define the variational expectation as:

Et (X ) := ess inf E [X |Ft ] + ct,T (P )
D
It can be proven that a BSDE

dYt = g(Zt )dt + Zt dBt
has a unique solution satisfying (Y, Z) satisfying YT = X and we have Yt =
Et (X ). Process Yt solving the above BSDE is called g-expectation. g-expectations
13 For
expectation with respect to probability measure P we will use notation E
18
share a lot of properties with classical expactations, but, most notably, they are
not linear. Some of the proeprties that g-expectations satisfy are monotonicity,
cash invariance, some kind of convexity, monotonic continuity and even a version
of dominated convergence theorem. Also, analogue of law of iterated expectations holds: for any s, t such that 0 s t T we have Es (X ) = Es (Et (X ))
Analogously to non-ambiguous case we can use g-expectations to define gmartingales and g-supermartingales. A process (St )t[0,T ] is called a g-(super)martingale
if we have Es (St ) = Ss (Es (St ) Ss ) for all 0 s t T . We note that DoobMeyer-type14 of decomposition exists for g-supermartingales. Namely, if S is
a g super martingale there exists an increasing c`adl`ag process A and a square
integrable process Z such that dVt = g(T, Zt ) + dAt Zt dBt 15 . This fact will
come in handy for deriving the results on optimal stopping below.
For details about all the relevant results related to g-expectataions and gmartingales we refer to [ChengandRiedel, 2010] and several papers (co)authored
by Shige Peng referenced there.
3.3
Optimal Stopping under -ignorance
We continue with presenting the theory of optimal stopping under -ignorance.

We keep the setting from the previous section and we suppose that the agent
evaluates her payoff at (random) time according to -ignorance as defined
before, that is Et (X ) := ess inf P P E P [X |Ft ]. The problem is to find the
best optimal stopping in the sense that it maximizes the payoff as calculated
by the agent. For that purpose, we introduce the value process:
Vt = ess sup Et (X )
(3.5)
TtT
We are looking for optimal time such that Vt = Et (X ).

As we have already mentioned, this problem has been extensively studied in
[Cheng and Riedel, 2010]. Here we state the theorem 3.1 from there, which gives
a general result about the existence of optimal stopping rules and its structure.
Theorem 3.1. For a process X satisfying above assumptions and V defined as
above we have:
1. There exists a version of V with rightcontinouus paths.
2. V is the smallest rightcontinuous g-supermartingale dominating Xt .
3. = inf{t 0|Vt = Xt } is an optimal stopping time
4. The value function stopped at , V (t ) is a g-martingale.
The similarities to the theorem ?????? are striking, and we can see that,
in a sense, all the useful properties of solution of an optimal stopping problem
are preserved in ambiguous setting. We note that the above result holds for the
more general case of ambiguity, as defined at the end of previous section. The
proof of this result can be found in the original paper.
14 In non-ambiguous setting Doob-Meyer decomposition states that every c
adl
ag supermartingale Xt admits a unique decomposition in the form X = X0 + MA where M is a c
adl
ag
local martingale null in 0, and A is a predictable process, increasing and null in 0.
15 For details, see Lemma A.1 in [Cheng and Riedel, 2010].
19
It is possible to reduce the problem of optimal stopping under -ignorance

to classical, single prior optimal stopping problem. Namely, it is possible to
identify a measure P P such that the value process of optimal stopping
in ambiguous setting coincides with non-ambiguous optimal stopping problem
under measure P . In order to do so, we have to identify a Girsanov kernel of
worse admissible measure which will yield us the measure P . In case that the
payoff is an increasing function of underlying Brownian motion, it is plausible
to assume that the worst possible drift will be obtaine for = . Similarly,
in case of decreasing payoff it should be = . In general, one may expect
that worst drift term takes these two values infinitely often, depending on the
local monotonicity of payoff. The following result, theorem 3.3 from [Cheng and
Riedel, 2010], gives precise answer to previous considerations.
Theorem 3.2. Suppose the agent evaluates expectations as above, i.e.:
Et [X ] = inf E [X |Ft ]
(3.6)
for some parameter > 0. Then there exists a proabiblity measure P P

such that
Vt = ess sup Et [X ] = ess sup E [X |Ft ]
(3.7)
Tt
Tt
Furthermore, optimal stopping times and worst case measures exist, and we have
the minimax relation:
max min E P [X ] = min max E P [X ]
P P
P P
(3.8)
Proof of this theorem relies on Doob-Meyer-Type decomposition of a gsupermartingales. This decomposition allows for a formalization of local monotonicity properties described above. Once we have a decomposition it is a matter
of applying the Girsanov theorem to find the desired probability measure and
obtain the result.
3.4
Optimal Stopping under -ignorance: Case with Diffusions
Let us finally turn to optimal stopping of a diffusion with drift ambiguity present.
As in section 2.4.2 we assume that we are given the diffusion
Z t
Z t
Wt = x +
(Wt ) dt +
(Wt ) dBt
0
where functions and satisfy the usual conditions. We further assume that
grows at most linearly and it is uniformly elliptic 16 ; these are trivially satisfied in
the case of geometric Brownian motion. Again, we denote with L the previously
introduced differential operator.
Same as before, we suppose that agents payoff is a function of the given
diffussion. Namely, we suppose that upon stopping at (random) time he
16 In a sense that x(x)2 k|x|2 for some k < 0. See assumption 3.5 in [Cheng and Riedel,
2010].
20
receives a payoff f (, W ), where f is a function satisfying certain regularity

condition that will be imposed later. Similarly as before, because we are in a
markovian setting we car describe the value process using the value function.
We would again like to obtain verification theorem that will allow us to confirm
that a candidate function v, that we chose/guessed is really a value function in
the sense that it satisfies v(t, Xt ) = Vt . The following result, a Theorem 3.6.
from [Cheng and Riedel, 2010], does exactly that:
Theorem 3.3. Let f : [0, T ] R R be a continuous function that satisfies a
following growth condition: there exists m N and a constant K > 0 such that:
|f (t, x)| K(1 + |x|)m
Let v : [0, T ] R R be an element of Sobolev space
nonlinear Hamilton-Jacobi-Bellman equation
max
(t,x)[0,T ]R
(3.9)
W1,2
that solves the
{f (t, x) v(t, x), vt (t, x) + Lv(t, x) |(x)vx (t, x)|} = 0 (3.10)
and the terminal condition

v(T, x) = f (T, x),
xR
Assume also that v and its generalized first derivatives satisfy a growth condition: for some n N and K > 0 we have:
|v(t, x)| + |vx (t, x)| K(1 + |x|)n
(3.11)
Then v is the value function of our optimal stopping problem, i.e. Vt = v(t, Xt )
The above theorem can be formulated to work with more general cases of
ambiguity, at the endo of section 3.2. The formulation presented here is a
special case for -ambiguity which makes it easy to apply it later in the context
of applications. Further details can be found in the original paper.
We see that the above HJB equation has similar form as in non-ambiguous
case. Now however we have an additional term which reflects the ambiguity
setting.
3.5
Infinite Time Horizon
In previous sections of this chapter we have considered optimal stopping under

-ignorance in finite time. However, our applications to irreversible stopping
problems will, similarly as before, be formulated in infinite time setting. Luckily,
all the results from previous section can be connected to infinite horizon case
with an elegant result from [Cheng and Riedel, 2010] that we present here.
Before we state the result we need some additional notation. The value
process defined on finite horizon [0, T ] as above will be denoted by V T . We
consider the stopping times satisfying P ( < ) = 1 for all P P . The
infinite time horizon problem can be then defined via following process: Vt :=
ess sup t Et (X ) = ess sup t ess inf P P E P [X ] It is obvious that for all T
we have V T V . Indeed, having an option to postpone the stopping can only
increase the value of the process - it cannont decrease it since we are still able
21
to stop at times previously chosen. Also, the values of V T are increasing in T .

Therefore the limit
V = lim V T
(3.12)
T
is well defined. As one would hope for, it can be proven (theorem 3.7, [Cheng
and Riedel, 2010]) that
lim V T = V
(3.13)
T
This result allows to use all the what was established in previous sections.
22
Irreversible Investment under Ambiguity
4.1
Introduction
In this chapter we return to considering a firm facing irreversible investment

decision as in the second chapter, but now we introduce ambiguity. We will
model ambiguity with -ignorance introduced in the previous chapter. This
will allow us to use all the tools developed in the previous chapter to perform
efficient analysis.
The problem of irreversible investment under ambiguity has been considered
in [Nishimura and Ozaki, 2007]. There, a slightly more general model is treated
than the one we present here. However, the main results remain the same and
nothing is effectively lost. We will not go over their proofs here. Instead, we
will use the results on optimal stopping under ambiguity (presented above) to
deliver the proofs. This approach is very efficient and, arguably, more elegant
one.
The chapter is organized as follows: 4.2 provides a simple example with the
purpose of providing intuition about ambiguous setting in our context. The
example provided there is example from second chapter modified to incorporate
ambiguity. In section 4.3 the analysis of problem set in continuous time is
performed and results are proven. Last section comments on comparative statics
and concludes the chapter.
4.2
Simple Example
In this section we continue the example from second chapter. This example,
with slight modifications, is taken from [Nishimura and Ozaki, 2007].
Again as before we consider a firm facing investment decisions in a two period
model that has to decide whether to invest and when. There are two states of
the world, boom and slump, described by probabilities pb and ps = 1 pb and
profits b and s . However, now the agent is not sure about the exact value
of pb , which is where ambiguity comes into play. To model this [Nishimura
and Ozaki, 2007] use -contamination, which can be considered a discrete time
counterpart of -ignorance. Namely, ambiguity is described by a parameter
such that P := [pb , pb + ] [0, 1]. The interpretation is that the agent does
not know the real value of pb , but knows that it belongs to interval P.
We have seen that when the value of pb is known the value of expected
1
(pb b + (1 pb )s ).
discount cash flow of investing in period 0 is 0 I + 1+r
Following [Gilboa and Schmeidler, 2004] the firm facing ambiguity evaluates its
discounted cash flow with following expression:

min
pb P

1
(pb b + (1 pb )s ) =
1+r

1
0 I +
s + min (b s )
pb P
1+r
0 I +
(4.1)
Similarly, in nonambiguous setting, the value of investing at period 1 was

I) which in ambiguous setting becomes:
pb
1+r (b
23

min
pb P

pb
1
(b I) =
min pb (b I)
1+r
1 + r pb P
(4.2)
From the above equations, after some simple regrouping of terms, it is easy
to conclude that firm postpones its investment decision if and only if:

1
s
+
min pb (I s ) < 0
(4.3)
(0 I) +
1 + r 1 + r pb P
Let us pause for a moment and compare this with the results of non-ambiguous
case. The postponement criterion in non-ambiguous case from equation 2.3 can
be rewritten as:
s
1
+
pb (I s ) < 0
(4.4)
1+r 1+r
This allows us to see directly the impact of ambiguity to investment decisions. If we identify the level of ambiguity with the value of parameter we see
that increase in ambiguity lowers the value of right-hand side in 4.3 (because
minpb P pb = pb ) so postponement is less likely. We can compare this with
the effect of increase in risk. As we have seen at the end of previous example
the increase in risk makes postponement more likely because it increases the
possible payoff of investing in second period. Increase in ambiguity makes postponement more likely for different reasons. The increase of level of ambiguity
actually lowers the expected payoff of investment (no matter in which period it
is made!) which makes postponement more likely.
(0 I) +
4.3
Main Results
We now turn to continuous case. We will keep the setting from chapter 2.
Namely, we suppose that we are given a finite time horizon [0, T ], probability
space (, F, P0 ), one-dimensional Brownian motion Bt and its augmented filtration Ft . We consider a geometric Brownian motion W with drift coefficient
and diffusion coefficient and agent who after investing in accordance to
optimal stopping time the receives payoff er (Wt I), where r > 0 is a given
discount rate and I is a given irreversible cost of investment.
Unlike before, we do not assume that agent knows the probability P0 . We
suppose that agent is ambiguity averse, and we model her ambiguity using ambiguity model introduced in previous chapter, for a given constant > 0.
As before we denote by denote by P a set of multiple priors prescribed by
-ambiguity model.
Following theory presented in previous chapter, we suppose that agent evaluates her payoff according to:
Et (er (Wt I)) = ess inf
E P [er (Wt I)|Ft ]
P P
(4.5)
and the value process is given with:

Vt = ess sup Et (er (Wt I))
TtT
24
(4.6)
As before, a firm with investment opportunity is looking for best time to

invest, or, more formally, for optimal stopping that maximizes the payoff function. We are also looking for explicit expression of value process/function; i.e.
we are looking for a function v that satisfies v(t, Wt ) = Vt . This completes the
setup of our problem of irreversible investment under ambiguity.
We now turn to find the solution, combining the results of non-ambigouous
case with results on optimal stopping under ambiguity. We have already seen
that firm behaves pessimistically in ambiguous setting in a sense that when it is
making decision it considers the worst possible probability measure, which, as
we saw in duality theorem 3.2, exists. We have also seen that -ignorance models
uncertainty about drift of underlying geometric Brownian motion. Then, intuitively, under worst probability measure, firms payoff will be the worst when
the drift is lowest possible, because that makes the expected payoff lowest. Following this reasoning firm could identify worst geometric Brownian motion as:
dWt = ( )Wt dt + Wt dBt
(4.7)
Let us for a moment consider a non-ambiguous irreversible investment problem under the above diffusion. Applying exactly the same analysis from the
second chapter we would obtain that the value function v is equal to
(

x
rt W
),
0 < x < W
e
(
W
(4.8)
v(t, x) =
rt
e (x I),
W x
q
2r
2
( 12
Where = 21
2 +
2 ) + 2 . We will now prove that this is the
value function of optimal stopping problem under ambiguity. By construction
v satisfied the classical non ambiguous HJB equation:
max(v(t, x) f (t, x), vt (t, x) + L v(t, x)) = 0
(4.9)
where L is a differential operator connected with geometric Brownian

2 2
2
+ 2x ) x
motion 4.7, i.e. L = (b )x x
2 (see equation 2.26). By direct
calculation we can see that the above equation reads as:
max(v(t, x) f (t, x), vt (x) + Lv(t, x) xvx (t, x)) = 0
(4.10)
where L is a diffusion operator associated with the real underlying diffusion

(given in equation 2.26).
On the other hand, by HJB for the ambiguous problem is:
max(v(t, x) f (t, x), vt (x) + Lv(t, x) |xvx (t, x)|) = 0
(4.11)
We see that the only difference between last two equations is in absolute
sign; if |xvx (t, x)| = xvx (t, x) holds then function v satisfies the above HJB
equation under ambiguity. But, from the explicit expression of function v (equation 4.8), we know that it is monotone in x. Further more, it is by construction
differentiable in every point, so vx (t, x) > 0 and , x > 0 by assumption. Therefore, we indeed have |xvx (t, x)| = xvx (t, x) and function v satisfies the HJB
equation in ambiguous case.
What is left now is to check if the v and f satisfy the growth conditions.
This has already been done for f (in non-ambiguous case). The fact that value
25
function in non-ambiguous case satisfied growth condition implies that function

defined above satisfies it as well: the only difference between the two function
is the value of parameter , so the same argument as there derives the solution.
We summarize the above analysis in following proposition:
Proposition 4.1. If value of the project is driven by geometric Brownian motion W (equation 2.4) and payoff from investing at time t is given by function
f = ert (Wt I) as described above then it is optimal to invest in accordance
with stopping time = inf{t | Wt W } as described above in which case value
function v is given with 4.8.
4.4
Conclusion
As in the end of second chapter, we conclude this chapter with a numerical

illustration. We take the same values of parameter as in section 2.6. That is we
take I = 1, = 0, = 0.2 and r = 0.04. As for the ambiguity parameter we
take = 0.25. This, when taking into account that I = 1 can be considered a
significant amount of uncertainty about underlying drift.
Before we present the values of boundaries and other model parameters that
depend on the ones we just fixed, let us comment on the economic aspects of
the model. Faced with ambiguity about the drift of the underlying geometric
Brownian motion the firm behaves pessimistically by taking into account the
worst possible drift. Hensce one would expect that, by lowering its expectation
2.0
1.5
1.0
0.5
0.5
1.0
1.5
2.0
2.5
3.0
-0.5
-1.0
Figure 2: Value function of irreversible investment problem under ambiguity

(full) and without ambiguity (thin) as well as the payoff function (dashed).
26
about growthh of value of the project the firm invests earlier, as it does not
allow itself to count on positive fluctuations as much. In a sense, a firm facing
ambiguity, should play it safe by not waiting the process value to reach the
value prescribed by non-ambiguous model.
This is intuition turns out to be correct as can be seen in figure 2. When we
plug above values of parameters into the formulas developed earlier we obtain
that W = 43 < 2 so the firm invests earlier than in the example in 2.6. More
generally, from the expression for it can be shown that investment decision in
ambiguous case always take place earlier than in its non-ambiguous counterpart.
Indeed, if we look at the expressions for (equation 2.30 ) in non ambiguous
case and (given after equation 4.8) it is clear that > . Since both
so we conclude that
and are greater than one, this implies that 1 < 1
firm waits less in ambiguous case.
From the above we see that the effect of ambiguity is opposite to that of
risk. The higher the ambiguity (as represented by the parameter ) the lower
the value function and earlier the investment is made. This is opposite to the
effect of risk as discussed at the end of section 2.6. Since we have discussed the
economic intuition behind both phenomena it is easy to conclude why the effects
are opposite. Namely, the benefits of increase of risk by potential increase of
value (without potential decrease!) are opposite to the cautions considerations
of lowest possible value of underlying drift (and thus lowest possible potential
increase of value!).
27
5
5.1
Insurable Irreversible Investment

Introduction
In this section we will consider how the irreversible investment decision, studied
in previous chapters, changes when the firm has the possibility to insure itself
against failure, i.e. negative market condition.
As we have already commented at the end of section 2.1, the firm with
irreversible investment opportunity can be considered a holder of certain call
option. Reasoning for that was quite straightforward: investment cost corresponded to price of the call, while the actual value of the project corresponded
to strike price of the underlying asset (in this case - the project under consideration). Similar to this reasoning, we can consider an insured firm a holder of a
put option. Now, the price of insurance corresponds to price of put and, again,
value of the firm corresponds to the strike price. Although conceptually simple the correspondence with financial instruments does not reflect the practical
complications of real options. As it is amusingly noted in [Brosch, 2008]:
... An investor can freely purchase a few calls and a few puts at various strike prices and create different trading strategies like straddles,
strangles, bull spreads, calendar spreads and so forth, whereas a firm
with real options cannot freely puchase two coal-fired power plants
at a certain implementation cost and short another nuclear power
plant at a different price to hedge the downside prices od electricity.
The key point is that market for real options is not as complete as for financial
derivatives. Nevertheless, certain opportunities can arise and some portfolios
of real options can be made. For example, a owner of the firm with investment
opportuinity can be able to buy a contract from another firm/institution allowing for selling of her firm at a specified cost. This is effectively a put option. But
since the firm she owns has also investment opportunity she can be considered a
holder of a certain call option. Therefore, the owner of the firm in this peculiar
situation has a straddle-like real option portfolio which can be analysed using
tools we have already developed, and this is exactly what we will do. We will
perform our analysis first in non-ambiguous setting, and then we will introduce
ambigutity modelled with -ignorance, as above.
Although not very common, there are some notable examples which quite
correspond to the situation just described. As a part of 2000.s multi-billion deal
between General Motors (GM) and Fiat the latter acquired the right, but not
the obligation, to sell its whole business to GM. Fiat opted for this because of
huge competitiveness of auto-maker business and huge risks over future earnings
the put option seemed attractive to Fiat, and later they even decided to excercise it17 . From this, and previous discussion, we can postulate that insurable
irreversible investment can be suitable for firms with investment opportunities
that are highly risky and can make or break the business.
We briefly note that, due to the comments from the beginning of this section,
our study of insurable irreversible investments that follows completely applies to
perpetual American straddles; cases with and without ambiguity are considered.
17 Interestingly, certain problems arised due to each sides interpretation of the original deal
which ultimately lead to court. For details see p.199. in [Kodukula and Papudesu, 2006].
28
Perpetual american straddles in non ambiguous setting have been studied by

several authors: [Beibel and Lerche, 1997], [Chiarella and Ziogas, 2005], [Gerber
and SH, 1994]. None of these uses the approach of partial differential equations
which we will employ. Perpetual american straddles under ambiguity are considered and correctly priced in Tatiana and Jorg [Chudjakow and Vorbrink, 2009].
American straddle under ambiguity where value project follows the simple, but
outdated, Bachelier model is studied in [Cheng and Riedel, 2010]. In this work,
we will tackle the problem of insurable irreversible investment (i.e. perpetual
american straddle) using HJB equation with and without ambiguity.
This chapter is organized simply as follows: in 5.2 consider the case of insurable irreversible investments without ambiguity and in 5.3 insurable irreversible
investments under ambiguity. Due to the closeness of solution we do not obtain
explicit results, so in section 5.2 we offer a numerical example.
5.2
Non-Ambiguous Case
In this section we adopt the setting from chapter 2. Namely, we are given a
filtered probability space and a one dimensional Brownian motion. The value of
the project is given with geometric Brownian motion Wt = Wt dt + Wt dBt .
For the sake of clear intuition and applicability we will keep the following
example in mind. Namely, suppose there is a midsize airline company A. Airline
company are often offered options to buy air planes by air plane manufacturers.
We suppose that company A is in posession of option to buy an airplane for a
price I > 0. We suppose that company made a special contract with another
airline company, company B, allowing it (but not obligating it) to sell them one
of their own airplanes. To keep matters simple, we suppose that the selling price
as stated in the contract is also I. We do not care about details how company
A got into possessions of this real option portfolio, although by computing the
value function we will effectively calculate how much should the company A be
willing to pay for it. Company A uses a given Brownian motion Wt to model the
price of each air plane at their possession at time t. In their calculations they
use a fixed discount rate r > 0. Obviously it is reasonable to exercise one only of
the options and company A wants to decide when is it optimal, if ever, to do so.
We see that their portfolio actually insures their investment opportunity from
negative market movements, which is why we call their portfolio a insurable
irreversible investment.
With this specific example in mind, we continue with performing the analysis
as in chapter 2. As we will see, we are in a slightly more complicated setting
which will not allow for explicit solution.
From what has been said we can deduce that payoff of company As real
options portfolio is f (t, Wt ) = ert |Wt I|. This allows us to apply the solution
method for optimal stopping developed earlier. We note that payoff in this case
is higher now than in the case considered in the case of non-insured irreversible
investment. Therefore the cases where discount rate does exceed value of drift
coefficient are still not interesting, for the same reasons as discussed there. We
therefore assume that r < .
Similarly as before, we introduce the value function with:
V (t, Wt ) = ess sup E[er |W I|]
Tt
29
(5.1)
Our goal is to find the best exercise policy, that is to find optimal stopping
such that: V ( , W ) = E[er |W I|]. We also want to find the

explicit representation of V . We will achieve all of this using methods of optimal
stopping, as before.
We follow the steps of constructing function v(t, x), the candidate for value
function, as discussed in section 2.5. First of all, we again suppose that v(t, x) =
et (x). Under this assumption, we have seen that on continuation region value
function should satisfy:
1
x < W0
r x0 (x) 2 00 (x) = 0,
2
As stated earlier, the solution of the above equation is given with:
(x) = Ax + Bx
(5.2)
(5.3)
where > 1, < 0 solve r m 21 2 m(m 1) = 0, i.e.:

r
1
1
= 2 + ( 2 )2 +
2
2
r
1
1
= 2 ( 2 )2 +
2
2
2r
2
2r
2
(5.4)
(5.5)
.
Although the problem changed, the ODE did not change. However, different
payoff function will yield different boundary conditions which will, of course,
lead to different solution. Let us discuss the new boundary conditions.
Intuitively, we expect that like before there will be a certain value of the
project (greater than I) up to which it is optimal to wait with the investment.
We further expect similar value to exist for exercising the insurance option.
That is, we expect there to be a value (lower than I) such that once the value
of the project drops beneath it, it will be optimal to sell. Formally we suppose
that continuation region is of the shape [
x, y] where x
and y are real numbers
such that x
< I < y. If this is the case we see that our value function will be of
the following form:
rt
0<xx
e (I x),
ert (Ax + Bx ), x
x y
v(t, x) =
(5.6)
rt
e (x I),
x > y
Already now we can see that, if we find the appropriate values of parameters A, B, x
and y, function v will satisfy the growth conditions required by
verification theorem 2.3 and thus it will be the value function. To find the
aforementioned values we will use the smooth pasting conditions, as explained
below.
As before, we expect the value function to be smooth. Hence we use the
smooth pasting conditions to make sure that value function is continuously
differentiable at the boundary of continuation region. In this case, smooth
pasting conditions will require that:
v(t, x
) = f (t, x
)
vx (t, x
) = fx (t, x
),
(5.7)
v(t, y) = f (t, y)
vx (t, y) = fx (t, y)
(5.8)
30
That is, at both boundaries, x

and y, value function and payoff function
should have equal values and the values of their derivatives should concide.
Knowing that v is of the form v(t, x) = ert (x) we are able to rewrite the
above smooth pasting conditions as:
0 (
x) = 1
(
x) = I x
(
y ) = y I
(
y) = 1
(5.9)
(5.10)
Finally knowing that function solves the above ODE and thus is of the form
(x) = Ax + Bx we obtain the following system of equations:
I x
=A
x + B x
(5.11)
x =A
x + B
x
y I =A
y + B y
(5.12)
(5.13)
x
=A
y + B
y
(5.14)
The above system is higly nonlinear. After several transformations and introduction of a new variable the above system can be reduced to a one-dimensional
system which has a solution in interval (0, 1). It turns out that this solution
completely characterizes the above problem. Here we formulate this result as a
proposition and in appendix we prove this in detail.
Proposition 5.1. There exists a unique solution of the system 5.11 5.14
satisfying all the above assumptions and it can be uniquely characterized with a
real number (0, 1) that satisfies:
I 1 +
I 1 +
= 0.
1
11+
1 1 + 1
(5.15)
The above proposition proves the existence of solution of system 5.11

5.14 and thus the solution to our economic problem of insurable irreversible
investment. Intuition and numerical analysis strongly imply that the solution of
the equation 5.15 is unique in interval (0,1); this would in turn imply that there
is a unique solution to system 5.11 5.14. However, due to serious nonlinearity
of 5.15 we were not able to prove uniqueness analytically and explicitly. Luckily,
it is not necessary: uniqueness can be proven by a bootstrapping argument.
That is, two different solutions of equation 5.15 would yield two different value
functions of optimal stopping problem which is not possible! More details are
offered in the appendix.
Finally we note that the above proposition paired up with numerical methods represents a powerful tool in calculating the solution of our optimal stopping
problem. Unique zero of a continuous function on a unit interval can be calculated easily using numerical methods. When we apply this to equation 5.15
using the construction of variable gamma offered in apendix, we can directly
calculate the approximation of a system 5.11 5.14 with as high precision as
needed.
With this we conclude the analysis of non-ambiguous case of insurable irreversible investment and turn to ambiguous case of the same problem.
31
5.3
Case with Ambiguity
We will now consider the problem of insurable irreversible investment posed

in previous section and we will introduce ambiguity as in chapter 4. That is,
we consider a firm holding two different real options and thus having de facto
insured investment opportunity. Ideally, we would like to perform the same
kind of analysis as before and obtain the solution as explicit as possible. As can
be expected, completely explicit solution will not be obtained. We do however
reduce reduce the problem to a two-dimensional system of equations one, using
techniques similarl to those as in proof of proposition 5.1.
The motivation of introducing ambiguity is same as in chapters 3 and 4: the
agent (in our case firm) is unsure about the probability measure over the states
of the world and has thus identified a set of possible measures and behaves, in
a sense described above, pessimistically with respect to it. The problem setting
is same as in previous section. That is: we have a firm owning a portfolio of
real options such that the payoff of exercising one of the options in the portfolio
at time t yields a payoff of f (t, Wt ) = ert |Wt I| where Wt is a given onedimensional geometric Brownian motion, I > 0 is the investment cost, and r
is a given discount rate. The only difference from the set up of the previous
section is the way in which firm evaluates its payoff. Similarly as in chapter 4
we set it to be:
Et (er |Wt I|) = ess inf
E P [er (Wt I)]
P P
(5.16)
where P is the set of multiple priors prescribed by -ignorance as explained in

chapter 2. The value process is given with:
Vt = ess sup Et |er (Wt I)|
(5.17)
Tt
As in previous analysis we are interested in finding optimal stopping time

and a value function v that satisfies v(t, Wt ) = Vt .
As we have seen from the duality theorem of optimal stopping under ambiguity (theorem 3.2) we know that worst measure for this problem exists. Having
in mind that -ignorance models ambiguity about underlying geometric Brownian motion we will try to guess how the Brownian motion under worst measure
looks like, similarly as we did in previous cases. The reasoning here is as follows: when the value of the underlying project goes above investment cost the
worst that can happen to firm is that the drift is lowest possible. That is, even
though the value is above investment cost, pessimistic (ambiguity averse) firm
fears that underlying drift is lowest possible and makes decisions accordingly.
Similarly, when the value of the project is bellow investment cost the firm fears
that it will go up thus reducing the payoff.
If we formalize this intuition we could guess that under the worst measure
firm behaves as if it considers the underlying Brownian motion to be
dWt = ( )Wt dt + Wt dBt
(5.18)
dWt = ( + )Wt dt + Wt dBt
(5.19)
when Wt > I, and

when Wt < I. To construct the value function we will we will need to take into
account both of these geometric Brownian motions on different intervals.
32
As in previous section, we again guess that the continuation region will be of

the form [
x, y] where x
< I < y. We further guess that on the region [I, +] the
value function of the problem will coincide with the classical, non-ambiguous
value function with underlying geometric Brownian motion given with 5.18.
Similarly we guess that on region [0, I] the value function will coincied with the
classical value function when underlying geometric Brownian motion given with
5.19.
If we again suppose that value function v is of the form v(t, x) = ert (x) we
will, applying the same procedure as in previous analysis, obtain two different
ODEs. These two differential equation will have two pairs of related quadratic
equations whose solutions we denote with {1 , 1 } and {2 , 2 } respectively.
Solution of first ODE would then be of the form w Ax1 + Bx1 for some
constants A and B and will coincide with it on interval [I, y]. Similarly, (x)
will coincide with (x) = Cx2 + Dx2 on interval [
x, I] for some constants C
and D. This would suggest that value function is of the form:
rt
e (I x),
0<xx
rt
xI
e (Cx2 + Dx2 ), x
(5.20)
v(t, x) =
ert (Ax1 + Bx1 ), I x y
rt
e (x I),
x > y
We could calculate the value of constants A, B, C and D, as well as boundaries x
and y by solving the system obtained by applying smooth fit conditions
in three critical points: x
, I and y. The reason why we have an additional critical point I is that function v is now defiened piecewise with four pieces instead
of three pieces as before, and thus smooth fit conditions must be applied to
all the ctitical point including I as a new critical point. This would give us a
nonlinear of system of six equations which we can, by similar transformations as
in non-ambiguous case, reduce to a two-dimensional problem. Due to the nature
of the obtained system, it seems that this is the most we can do analytically.
All of the above heuristic analysis can be formalized directly and analogously
to all the previous analysis of the value function. Procedure is slightly more
complicated due to additional critical point I and is notationally significantly
more cumbersome. We therefore summarize the above considerations in the
following proposition, and give all the technical details in the proof of proposition
which can be found in appendix.
Proposition 5.2. If there exist a unique 6-tuple (A, B, C, D, x
, y), with 0 <
x
< I < y satisfying
I x
=C x
2 + D
x2
x =C2 x
(5.21)
+ D2 x
y I =A
y 1 + B y1
1
x
=A
y
C2 I
CI 2
2
+ DI
+ D2 I
=AI
=AI
33
+ B
y
1
+ BI
(5.22)
(5.23)
+ BI
(5.24)
(5.25)
(5.26)
where
1 =
1 =
2 =
2 =
1
2
1
2
1
2
1
2

2

2
+
2
+
2
1
(
2
r
1
(
2
r
1
+ (
2
r
1
+ (
2
+
2
) +
2
2
) +
2
+ 2
) +
2
+ 2
) +
2
2r
2
2r
2
2r
2
2r
.
2
(5.27)
(5.28)
(5.29)
(5.30)
then value function of the insurable irreversible investment problem under

ambiguity (as described above) is given with 5.20.
Furthermore, the above system can be reduced to a two-dimensional nonlinear system with variables x
and y and a unique solution satifying 0 < x
<
I < y.
5.4
Conclusion
At the very end we offer a numerical illustration for the non-ambiguous case of
insurable irreversible investment. We take the same values of parameteres as in
4.4. That is we take I = 1, = 0, = 0.2, r = 0.04 and = 0.25. In figure
3 we see a graph with value function and payoff function in case of insurabe
irreversible investment.
We see that the convexity of the payoff function yields different shape of
value function, with two stopping regions. For the above values, the value of
the boundaries have been calculated to be approximately: y = 1.76725 and
x
= 0.331557. We note that the upper value of waiting is greater than in non
2.0
1.5
1.0
0.5
0.5
1.0
1.5
2.0
2.5
3.0
Figure 3: Value function of insurable irreversible investment problem under

ambiguity (full) as well as the payoff function (dashed).
34
insured case because insurance adds value to the project. Parameters A and B
have been calculated to be A = 0.0490018 and B = 0.384555.
Similarly as before we can reason that increase of risk (as represented by
volatility parameter ) would lead to widening of the waiting region: as
increases the value of upper boundary increases, while value of lower boundary
decreases. This is well in accordance with our economic intuition of the effect
of risk on real options as described in section 2.6.
As for the case with ambiguity, although we do not provide an example,
we make a comment. The insight in parallelism between cases in ambiguity
and non-ambiguity is the same as between examples of sections 2.6 and 4.4:
ambiguity lowers the value of investment opportunity and narrows the waiting
region. That is, upper boundary of continuation region in non-ambiguous case is
higher than the one in the respective case with ambiguity, while the opposite is
true for lower boundaries. Graphically, the value function would have the same
shape like the one in figure 3, but would be bellow it, similar to the situation
we had in figure 2 in section 4.4.
35
Concluding Remarks
In this work we have demonstrated application of optimal stopping theory to

problem of irreversible investment. We have used geometric Brownian motion
to model the movement of value of underlying project and have considered cases
with and without ambiguity about its drift. To model ambiguity we have used
the simple and intuitive model of -ignorance. Finally, at the end we considered
a portfolio of real options which makes the investment option insured (thus
making the portfolio straddle-like) and performed the same analysis about
best excercise of options in portfolio.
As we have said in the earlier chapters, the model of geometric Brownian
motion could be replaced with more plausible models of the movement of value
of underlying project. Similarly, different models of ambiguity could be considered, as indicated in the section that spoke about more general ways to model
ambiguity. Both of these would make the analysis more general and applicable,
but also more complex. In that sense, the work presented here could be seen as a
guideline of expected results in those more complex settings since the economic
situations we model would remain the same.
Finally, portfolios of real options that make irreversible investment option
insured could be further studied. Different kinds of insurance with different
kinds of options are possible, and it would be interesting to explore which are
most realistic and most useful. All of this represents a possible base for the
future research.
36
Proof of Proposition 5.1
In this appendix we offer a proof of of proposition 5.1.

First we comment a bit more detailly on the fact that the system cannot have
more then one solution satisfying x
< I < y. To see this, let us suppose there
are two different solutions, and let us denote the corresponding value functions
(as defined in 5.6) with v1 and v2 . Because of the form of the value function
(again equation 5.6) both of these functions satisfy verification theorem and
therefore are value functions in a sense that vi (t, Wt ) = Vt , i = 1, 2. This is due
to fact that we constructed functions v1 and v2 such that they satisfy HJB and
they havediscounted quasipolynomial form. But this would then imply that
equality v1 (t, Wt ) = v2 (t, Wt ) holds P -almost surely, which is obviously not the
case for any two different sets of solution! Therefore the solution of the system
5.11 5.14, if it exists, is unique.
We now turn to proving the existence. In first step we eliminate variables A
and B, and later we replace a two-dimensional system with variables x
and y
with a one dimensional one featuring new variable .
To eliminate variables A and B we begin by treating equations 5.11 5.12
as a two dimensional linear system with variables A and B. Determinant of
that system is D = x
+ ( ) which is always different then zero because
x
> 0, > . This means that for any value of x
variables A and B are
uniquely determined by:
1
((1 )
x1 +
x )
1
B=
((1 )
x1 +
x )
A=
(A.1)
(A.2)
Before we proceed, let us introduce the following functions that will offer
some valuable insight about solution bellow:
A(x) :=(1 )
x1 +
x
(A.3)
(A.4)
B(x) :=(1 )
x
+
x
Equations A.1 and A.2 can now be rewritten as:

1
A(
x)
1
B=
B(
x)
A=
(A.5)
(A.6)
By analogous argument and direct calculation we obtain from equations 5.11

5.12 following values of variables A and B in terms of y:
1
A(
y)
1
B=
B(
y)
A=
37
(A.7)
(A.8)
The natural idea now is to equate expressions for A and B and obtain a
nonlinear system with two equations and two variables, x
and y. When we do
so, after cancelling out unnecessary coefficients and rearanging, we obtain the
following two equations:
A(
x) + A(
y) = 0
B(
x) + B(
y) = 0
(A.9)
Due to the nice form of the above system, we immediately see that if (
x, y) is
a solution of A.9 so is (
y, x
). This means that for every pair of solutions there is
a unique member of the pair satisfying x
< y, and it will be the unique solution
that we are looking for.
We now proceed to reducing the system A.9 to a one-dimensional one. Let
us introduce a variable such that x
= y. Since inequality 0 < x
< y holds,
we have (0, 1). The right hand side of the first equation of the system A.9
can now, after some simple calculations, be writen as:
A( y) + A(
y ) = . . . = (1 )
y 1 (1 + 1 ) +
y (1 + ).
Using this, after multiplying the equation A(
x) + A(
y ) = 0 with x
we are left
with equation:
(1 )
y (1 + 1 ) + (1 + ),
from which we obtain:
y =
I 1 +
1 1 + 1
(A.10)
Similarly, by changing x
= y in B(
x) + B(
y ) = 0 after multiplication with
x
we could obtain:
I 1 +
y =
(A.11)
1 1 + 1
Equating two obtained expressions for y, after rearanging and cancelling out
parameter I, we obtain a one-dimensional equation:
1 +
1 +
=0
1 1 + 1
1 1 + 1
(A.12)
With this equation we have reduced our original four-dimensional system to

a one-dimensional system and we are looking for solution only on interval (0, 1).
We will now prove that the solution exists. Indeed, if we denote the right hand
side with h(). Obviously h is continuous on (0, 1). Further more, following
holds:
I
I
h(1) =
=I
<0
1 1
( 1)( 1)
and since lim0+
1+
1+ 1
= + we have
lim h() = +.
0+
and we conclude, by continuity of h, that there exists a solution of A.12 in

interval (0, 1). To see that solution is unique, we use the same argument as in
the beginning of this appendix. By construction of , each (0, 1) that solves
38
A.12 yields a different solution of the original system. Therefore, the solution
of the above equation is unique.
With this the proposition 5.1 is proven. At the very end, we note an interesting fact: value of does not depend on I. That is, the coefficient of
proportion between left and right boundary of stopping region is constant for
different values of investment cost.
39
Proof of Proposition 5.2.
Here we turn to proving proposition 5.2 by formalizing the considerations that

preceeded it and building upon them.
We have already guessed that v is of the form, v(t, x) = ert (x). Since
we have already identified the diffusion that value project follows under worst
measure (equation 5.18) we further guess that on region [I, +] value function
v satisfies classical Bellman equation under 5.18, that is:
max(v(t, x) f (t, x), vt (t, x) + L v(t, x)) = 0
(B.1)
where L
is a differential operator connected with geometric Brownian
2 2
2
+ 2x ) x
motion 5.18, i.e. L = (b )x x
2 . By direct calculation we see
that this yields:
max(v(t, x) f (t, x), vt (x) + Lv(t, x) xvx (t, x)) = 0
(B.2)
where L is the differential operator of the original diffusion. This means that
following ODE is satified on region [I, y]:
1
r ( )x0 (x) 2 x2 00 (x) = 0,
x < W0
2
As we have already seen, the above ODE has solution of the type
(x) = Ax1 + Bx1
A, B R
(B.3)
(B.4)
where
r
1 2
1
1 =
+ (
) +
2
2
2
2
r
1
1 2
1 =
(
) +
2
2
2
2
2r
2
2r
2
(B.5)
(B.6)
On the other hand, by similar reasoning we can conclude that on the region
[0, I] the following form of the HBJ equation is satisfied:
max(v(t, x) f (t, x), vt (t, x) + L+ v(t, x)) = 0
(B.7)
where L+ is a differential operator connected with geometric Brownian

motion 5.19. Last equation is equivalent to
max(v(t, x) f (t, x), vt (x) + Lv(t, x) + xvx (t, x)) = 0
(B.8)
which implies that on the on the interval [

x, I] following ODE is satisfied:
1
r ( + )x0 (x) 2 x2 00 (x) = 0,
2
Solutions of the last ODE is given with
(x) = Cx2 + Dx2
where
40
C, D R
x < W0
(B.9)
(B.10)
r
1 +
1 + 2
2 =
+ (
) +
2
2
2
2
r
1 +
1 + 2
2 =
+ (
) +
2
2
2
2
2r
2
2r
2
(B.11)
(B.12)
With this, we expect, by construction of function and thus v, that function

v will be given with 5.20. We will use smooth fit conditions to make sure that
the function is continuous and differentiable everywhere. Smooth fit conditions,
considering the form of function v, are:
v(t, x
) = f (t, x
)
lim v(t, x) = lim v(t, x)
xI
xI+
v(t, y) = f (t, y)
vx (t, x
) = fx (t, x
),
lim vx (t, x) = lim vx (t, x)
xI
xI+
vx (t, y) = fx (t, y)
(B.13)
(B.14)
(B.15)
Replacing v with ert (x), after canselling out ert we obtain:

(
x) = I x
0 (
x) = 1
lim (x) = lim (x)
xI
lim (x) = lim (x)
xI+
(
y ) = y I
(B.16)
xI
0
(
y) = 1
xI+
(B.17)
(B.18)
x, I] (equation B.10)
We know that coincides with Cx2 + Dx2 on interval [
and with Ax1 +Bx1 on interval [I, y] (equation B.4). This allows us to rewrite
the above system exactly as the system stated in proposition!
By assumption of the theorem the system has unique solution. That solution defines function v which, by construction, satisfies non-linear HJB equation
given in verification theorem???? Conditions on growth of payoff function, value
function and its derivative are easily satisfied due to discounted quasipolynomial form of the function. Therefore, function v, as given in 5.20 is a value
function of the problem of insurable irreversible investment.
To prove the second part of the theorem we first notice that equations related
to smooth pasting in I (equations 5.24 and 5.26) represent a linear system with
variables A, B, C and D. This means that there exist numbers pC , qC , pD , qD
such that
C = pC A + qC B
D = pD A + qD B
(B.19)
41
On the other hand if we treat equations 5.21 and 5.22 as a linear system with
variable C and D we can obtain C = C(
x) and D = D(
x) for some functions
C(x) and D(x), similarly as in proof of theorem 5.1. Similarly, from equations
5.23 and 5.24 we can obtain A = A(
y ) and B = B(
y ) for some functions A(y)
and B(y). Plugging this into equations B.19 we obtain:
C(
x) = pC A(
y ) + qC B(
y)
D(
x) = pD A(
y ) + qD B(
y)
(B.20)
With this we reduced the original system to 2-dimensional one as we set

out to do. Using the same bootstrapping argument that we used to prove
uniqueness in theorem 5.1 we can prove the uniqueness in this case too. This
completes the proof.
42
Proof of Verification Theorem 2.3
As we have already said, the theorem 2.3 is just a non-ambiguous version of the
theorem 3.3. Hence, approprietly, the proof we offer here is a simplified version
of the proof of theorem 3.3 as found in [Cheng and Riedel, 2010].
Since v is in W1,2 we can apply Krylovs generalized version of Itos formula
([Krylov, 2008], theorem 1.10.1). With the help of HJB equation stated in the
theorem we get:
Z
v(t, Wt ) =v(, Wt )
(vt (u, Wu ) + Lv(u, Wu )) du

Zt
=v(, Wt )
vx (u, Wu )(Wu ) du
t
vx (u, Wu )(Wu ) du + A At
(C.1)
where
Z
At =
(vt (u, Wu ) + Lv(u, Wu )) du.
(C.2)
Due to HJB equation we know that the under-integrand

expression is nonR
positive, hense proces A is increasing. Since t vx (u, Wu )(Wu ) du is a martingale we conclude that v(t, Wt ) is a super martingale. Our general theorem
implies that v(t, Wt ) St is for all t St .
Let us introduce the stopping time = inf {u geqt | v(t, Wt ) = f (t, Wt )}. Between t ant we have that f < v which, by HJB, implies vt (u, Wu )+Lv(u, Wu ) =
, Wu ) is a martingale by the
0. We can conclude that Atau
At = 0 so v(u
above expression of v developed by generalized Ito formula. By continuity of v
adn f and continuity of sample paths of Wt we also have, v(
, W ) = f (
, W ).
Using definition of S we have that:
St E[f (
, W )|F] = E[v(
, W )|F].
But by optional sampling theorem E[v(
, W )|F] = v(t, Wt ) so:v(t, Wt ) St .
This, combined with already proven opposite inequality, completes the proof of
theorem 2.3.
43
References
M. Beibel and HR Lerche. A new look at optimal stopping problems related to
mathematical finance. Statistica Sinica, 7:93108, 1997.
R. Brosch. Portfolios of real options. Springer-Verlag., 2008.
Z. Chen and L. Epstein. Ambiguity, risk, and asset returns in continuous time.
Econometrica, 70(4):14031443, 2002.
Xue Cheng and Frank Riedel. Optimal stopping under ambiguity in continuous time. Working Papers 429, Bielefeld University, Institute of Mathematical Economics, 2010. URL http://econpapers.repec.org/RePEc:bie:
wpaper:429.
C. Chiarella and A. Ziogas. Evaluation of american strangles. Journal of Economic Dynamics and Control, 29(1-2):3162, 2005.
T. Chudjakow and J. Vorbrink. Exercise strategies for american exotic options
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A.K. Dixit and R.S. Pindyck. Investment under uncertainty. Princeton University Press Princeton, NJ, 1994.
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H.U. Gerber and E.S.W. SH. Martingale approach to pricing perpetual american
options. ASTIN, page 195, 1994.
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birthday, 63:125, 2004.
P. Kodukula and C. Papudesu. Project valuation using real options: a practitioners guide. J Ross Pub, 2006.
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Journal of Economics, 101(4):707, 1986.
K.G. Nishimura and H. Ozaki. Irreversible investment and knightian uncertainty. Journal of Economic Theory, 136(1):668694, 2007.
B. ksendal. Stochastic differential equations. universitext, 2003.
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2009.
44
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have been properly acknowledged, and the assessment task contains no plagiarism. I have not previously submitted this work or any version of it for
assessment in any other unit or award offered by Bielefeld University or any
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Bielefeld, July 1, 2011

Lazar Obradovic
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On Insurable Irreversible Investments under Ambiguity

3 Optimal Stopping under Ambiguity

4 Irreversible Investment under Ambiguity

5 Insurable Irreversible Investment

A Proof of Proposition 5.1

B Proof of Proposition 5.2.

C Proof of Verification Theorem 2.3

On Insurable Irreversible Investments under Ambiguity

On Insurable Irreversible Investments under Ambiguity

On Insurable Irreversible Investments under Ambiguity

Here we present a simple example that is a useful starting point in developing of

On Insurable Irreversible Investments under Ambiguity

On Insurable Irreversible Investments under Ambiguity

General Model: Set up

where R and R are two constants. Further properties of these two

Relevant Optimal Stopping Results

On Insurable Irreversible Investments under Ambiguity

satisfies the following two properties:

stopping time : [0, T ] [0, T ] is a process satisfying (t [0, T ]) < t Ft

On Insurable Irreversible Investments under Ambiguity

1. For each I we have P (Z Z ) = 1.

The process S = (St )t[0,T ] is often refered to as a Snell envelope of X.

Since St Gs (by definition of essential supremum), stopping time t tells us

St E[X |Ft ] for each Tt

Then for all t 0 we have:

On Insurable Irreversible Investments under Ambiguity

3. The process (Ss )st is a smallest right-continous supermartingale which

Case with Diffusions

Above results on optimal stopping were of general kind: almost no requirements

We assume that the starting point W0 = x R is known.

We note here that W satisfies a strong Markov property6 .

Vt = sup E[f (Wx )]

E[f (Xx+h )|F ] = E[f (XhX )]

On Insurable Irreversible Investments under Ambiguity

Theorem 2.3. Let f : [0, T ] R R be a continuous function that satisfies a

that solves the

{f (t, x) v(t, x), vt (t, x) + Lv(t, x)} = 0

and the terminal condition

On Insurable Irreversible Investments under Ambiguity

General Model: Results

Equipped with appropriate tools we proceed to solving the problem posted in

from [Nishimura and Ozaki, 2007].

On Insurable Irreversible Investments under Ambiguity

We proceed by finding values A and B, and W .

is a standard trick when dealing with optimal control of discounted functions.

On Insurable Irreversible Investments under Ambiguity

f on stopping region. Thus, we have imposed piecewise conditions on our

which is equivalent to:

This means that function v is of the form:

and, of course, optimal time is then given by = inf{t | Wt W } = inf{t | f (t, Wt ) =

Figure 1: Value function of irreversible investment problem (full) and payoff

On Insurable Irreversible Investments under Ambiguity

In previous section we have considered a provblem of irreversible investmenet

On Insurable Irreversible Investments under Ambiguity

Optimal Stopping under Ambiguity

Ambiguity Model -ignorance

On Insurable Irreversible Investments under Ambiguity

Let (, F, P0 ) be a probability space. Suppose that we are in a finite setting,

We see that every member of easily satisfies Novikovs condition12 . This

such that P and P0 are equivalent, and a process B defined with:

is a standard Brownian motion with respect to P .