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Market Risk, Policy Uncertainty and Overinvestment--An Analysis Based on Option Game
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TitleMarket Risk, Policy Uncertainty and Overinvestment--An Analysis Based on Option Game  
AuthorShaoling Chen ,Haisheng Yang and Guangzhong Li  
OrganizationJinan University; Sun Yat-Sen University 
Key WordsMarket Risk; Policy Uncertainty; Overinvestment; Option Game 
AbstractInvestment under uncertainty is one critical topic in modern firm theory. Empirical evidence from both macro- and micro-levels has shown that firms in China have an obvious inclination to overinvestment. Then, what is the relationship between uncertainty and overinvestment? Based on an incomplete information option game, we structure the dynamic investment decision-making scheme of firms under heterogeneous uncertainty, through which we also propose one quantitative measure for the degree of overinvestment—Overinvestment Rate (OIR). Our theoretical and numerical analyses suggest that: (1) market risk constrains investments, but policy uncertainty somehow accelerates investments; (2) policy persistency helps to depress overinvestment; (3) policy uncertainty has a greater impact on overinvestment than market risk; (4) a firm’s investment strategy in response to these two uncertainty are strategically substitute, implying that an increase in the market risk will constraint the impacts of macroeconomic policies on investments. Finally, we employ the monthly data to calibrate the actual investment behavior of the real estate firms in China from 1998 to 2012. We find that a real estate firm’s OIR increased significantly during periods with a lower market risk and/or during the transition of policies. Moreover, the impacts of a policy on investments would shrink over time. 
Serial NumberWP628 
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