Optimal Entry and Exit Decisions Under Uncertainty and the Impact of Mean Reversion

Abstract

This paper derives an entrepreneur’s optimal switching between an idle and an active state under stochastic mean reverting output prices. The paper suggests a new categorisation of the effects of mean reversion. Mean reversion affects valuation and optimal entry and exit thresholds via the variance of output prices and expected future cashflows. High variance increases the value of optionality and enhances hysteresis effects. Changes to the expected cashflow path affect the attractiveness of the active relative to the idle state. In addition, changes to the moments affect the implicit risk discounting rate and thereby valuation and the optimal switching strategy.