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OPTION EXERCISE GAMES: THE INTERSECTION OF REAL OPTIONS AND GAME THEORY
Author(s) -
Grenadier Steven R.
Publication year - 2000
Publication title -
journal of applied corporate finance
Language(s) - English
Resource type - Journals
eISSN - 1745-6622
pISSN - 1078-1196
DOI - 10.1111/j.1745-6622.2000.tb00057.x
Subject(s) - preemption , real estate , vesting , intersection (aeronautics) , option value , economics , investment (military) , asset (computer security) , game theory , actuarial science , computer science , microeconomics , risk analysis (engineering) , business , finance , incentive , engineering , art , computer security , politics , law , political science , visual arts , aerospace engineering , operating system
While the real options approach has proven useful in providing an analytical framework for analyzing the timing of investment decisions, a notable failure of the approach has been an almost complete lack of strategic considerations. In standard real options models, invest‐ment (and exercise) strategies are for‐mulated in isolation, without considering the potential impact of other firms' exercise strategies. This paper illustrates how the intersection of real options and game theory provides powerful new insights into the behavior of economic agents under uncertainty. Introducing strategic considerations into the real options framework can lead to a rethinking of standard real option analysis. For example, one of‐ten cited conclusion of the real options literature is the overturning of the standard capital budgeting rule of in‐vesting immediately in any project with a positive NPV. Because the fu‐ture value of the asset is uncertain, there may be significant benefits to deferring the investment until condi‐tions prove even more favorable. But this result clearly depends on the lack of competitive access to the project. If firms fear preemption, then the option to wait becomes less valuable. For example, while the standard real op‐tions models suggest that a real estate developer should wait until the devel‐opment option is considerably “in the money,” competition and the fear of preemption will likely force develop‐ers to build much earlier.