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