Strategic Real Options

46 Pages Posted: 18 Jul 2017 Last revised: 13 Apr 2018

See all articles by Aaron Kolb

Aaron Kolb

Indiana University - Kelley School of Business - Department of Business Economics & Public Policy

Date Written: February 18, 2018


Suppose a project manager is developing a product and wishes to sell it to a particular buyer who learns over time whether the product is profitable. I analyze situations like this with a real options model in which the seller of an asset has private information about its quality and can either wait (and incur a flow cost), exit the market, or upgrade the quality (at a hidden, lump-sum cost). The buyer learns about the asset’s quality from exogenous news and chooses when to exercise an option to buy it.

For low upgrade costs, multiple equilibria exist and the seller may be endogenously motivated by failure or by success. When motivated by failure, the low-type seller waits until his reputation hits “rock bottom” and then upgrades with a large probability, inducing upward reputational jumps in equilibrium. The seller may then exit at intermediate reputations, inducing upward reputational skews. When motivated by success, the seller upgrades when his reputation is in a “sweet spot” region, also inducing upward reputational skews. Reputational jumps and skews manifest technically as resetting barriers and skew Brownian motion, generalizing the notion of a reflecting barrier.

Keywords: Real Options, Bayesian Learning, Hidden Investment, Continuous Time, Resetting Barrier, Skew Brownian Motion

Suggested Citation

Kolb, Aaron, Strategic Real Options (February 18, 2018). Kelley School of Business Research Paper No. 17-51. Available at SSRN: or

Aaron Kolb (Contact Author)

Indiana University - Kelley School of Business - Department of Business Economics & Public Policy ( email )

Bloomington, IN 47405
United States

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