Auctions of Real Options

Abstract

Governments and corporations frequently auction assets with embedded real options using both cash and contingent bids. I characterize equilibrium bidding and option exercise strategies, and find that the moral hazard associated with uncontractible investment timing inefficiently and asymmetrically accelerates or delays investments. I use a mechanism design approach instead of the conventional"steepness'" concept to rank securities and derive the optimal security. Furthermore, without sellers' commitment to the security design, as seen in informal auctions such as corporate acquisitions, all auction equilibria are equivalent to cash auctions, and investments are socially efficient. The results are broadly consistent with empirical observations, for example in the sales of oil leases.

Keywords: Auctions; Acquisitions; Oil and Gas; Real Options; Security Design; Timing Games.

JEL Classification: D44; D81; D82; G13; G31; G32; L24