OPTIMAL EXIT FROM A DETERIORATING PROJECT WITH NOISY RETURNS

We consider the problem of determining when to exit an investment whose cumulative return follows a Brownian motion with drift μ and volatility σ2. After an unobserved exponential amount of time, the drift drops from μH > 0 to μL < 0. Using results from stochastic differential equations, we are able to show that it is optimal to exit the first time the posterior probability of being in the low state falls to p*, where the value of p* is given implicitly. We effect a complete comparative statics analysis; one surprising result is that a decrease in μL is beneficial when |μL| is large.