Strategic exercise of real options: Investment decisions in technological systems

Abstract

Viewing investment projects in new technologies as real options, this paper studies the effects of endogenous competition and asymmetric information on the strategic exercise of real options. We first develop a multi-period, game-theoretic model and show how competition leads to early exercise and aggressive investment behaviors and how competition erodes option values. We then relax the typical full-information assumption found in the literature and allow information asymmetry to exist across firms. Our model shows, in contrast to the literature that payoff is independent of the ordering of exercise, that the sequential exercise of real options may generate both informational and payoff externalities. We also find some surprising but interesting results such as having more information is not necessarily better.

Keywords

Technology investment / competition / real options / game theory / dynamic games / incomplete information / technological systems / and technology innovation

References

[1] Back K.. Asymmetric information and options. Review of Financial Studies, 1993, 6: 435-472.

[2] Baldwin C., Clark K.. Modularity-in-design: An analysis based on the theory of real options, 1994, Cambridge, MA: Harvard Business School

[3] Banerjee A.V.. A simple model of herd behavior. Quarterly Journal of Economics, 1992, 107(3): 797-817.

[4] Barua, A., and T. Mukhopadhyay, “Information technology and business performance: Past, present and future,” in Framing the Domains of IT Management: Projecting the Future through the Past, R.W. Zmud (ed.), Pinnaflex Education Resources, Inc., 2000.

[5] Brennan M., Schwartz E.. Evaluating natural resource investments. Journal of Business, 1985, 58(2): 135-157.

[6] Chamley C., Gale D.. Information revelation and strategic delay in a model of investment. Econometrica, 1994, 62(5): 1065-1085.

[7] Cho I.-K., Kreps D.. Signaling games and stable equilibria. Quarterly Journal of Economics, 1987, 102(2): 179-221.

[8] Constantinides G.M.. Warrant exercise and bond conversion in competitive market. Journal of Financial Economics, 1984, 13: 371-397.

[9] Cox J.C., Ingersoll J.E., Ross S.A.. An inter temporal general equilibrium model of asset prices. Econometrica, 1985, 53: 363-384.

[10] Detemple J., Selden L.. A general equilibrium analysis of option and stock market interactions. International Economic Review, 1991, 32: 279-303.

[11] Dixit A.K., Pindyck R. S.. Investment under Uncertainty, 1994, Princeton, NJ: Princeton University Press

[12] Emanuel D.C.. Warrant valuation and exercise strategy. Journal of Financial Economics, 1983, 12: 211-235.

[13] Fudenberg D., Tirole J.. Game Theory, 1991, Cambridge, MA: MIT Press

[14] Grenadier S.R.. The strategic exercise of options: development cascades and overbuilding in real estate markets. Journal of Finance, 1996, 51(5): 1653-1679.

[15] Grenadier S.R., Weiss A.. Investment in technological innovations: An option pricing approach. Journal of Financial Economics, 1997, 44: 397-416.

[16] Grenadier S.R.. Information revelation through option exercise. Review of Financial Studies, 1999, 12(1): 95-129.

[17] Hendricks K., Kovenock D.. Asymmetric information, information externalities, and efficiency: the case of oil exploration. Rand Journal of Economics, 1989, 20(2): 164-182.

[18] Joaquin, D.C. and K.C. Butler, Competitive investment decisions: a synthesis, in New Developments in the Theory and Applications of Real Options, by M.J. Brennan and L. Trigeorgis (eds.), Oxford University Press, 2000.

[19] Kreps D., Milgrom P., Roberts J., Wilson R.. Rational cooperation in the finitely repeated Prisoner’s Dilemma. Journal of Economic Theory, 1982, 27: 245-252.

[20] Kreps D., Wilson R.. Sequential equilibrium. Econometrica, 1982, 50(4): 863-894.

[21] Kyle A.S.. Continuous auctions and insider trading. Econometrica, 1985, 53: 1315-1335.

[22] Luenberger D. G.. Investment Science, 1998, New York, NY: Oxford University Press

[23] Majd S., Pindyck R.. Time to build, option value, and investment decisions. Journal of Financial Economics, 1987, 18(1): 7-27.

[24] McDonald R., Siegel D.. The value of waiting to invest. Quarterly Journal of Economics, 1986, 104(1): 707-727.

[25] Merton, Robert, C., Nobel Lecture, Applications of Option-Pricing Theory: Twenty-Five Years Later, December 9, The Nobel Foundation, 1997.

[26] Paddock J.L., Siegel D.R., Smith J.L.. Option valuation of claims on real assets: the case of offshore petroleum leases. The Quarterly Journal of Economics, 1988, 103: 479-508.

[27] Smit, H.T.J. and L. Trigeorgis, “R&D Option Strategies”, working paper, Erasmus University and University of Chicago, 1998.

[28] Spatt C.S., Sterbenz F.T.. Warrant exercise, dividends, and reinvestment policy. Journal of Finance, 1988, 43: 493-506.

[29] Tallon P., Kauffman R., Lucas H., Whinston A., Zhu K.. Using real options analysis for evaluating uncertain investments in information technology. Communications of the Association for Information Systems (CAIS), 2002, 8: 136-167.

[30] Trigeorgis L.. Real Options, 1996, Cambridge, MA: The MIT Press

[31] Williams J.T.. Equilibrium and options on real assets. Review of Financial Studies, 1993, 6: 825-850.

[32] Zhu, K., “Evaluating information technology investment: cash flows or growth options?” Workshop on Information Systems and Economics (WISE), Charlotte, NC, Dec. 11–12, 1999a.

[33] Zhu, K., Strategic Investment in Information Technologies: A Real-Options and Game-Theoretic Approach, Unpublished Doctoral Dissertation, Stanford University, Stanford, CA, 1999b.