The Strategic Exercise of Options: An Application to Real Estate Development
Posted: 15 Jul 1998
Date Written: Undated
Real-world situations do not always allow one to formulate an optimal option exercise strategy in isolation. While one person may be solving a partial-differential equation with its associated smooth-pasting condition, a competitor may be doing likewise. In the example of real estate development, these calculations cannot be conducted separately, but must be done as part of a strategic equilibrium. The model demonstrates that development options might be exercised sequentially, or simultaneously, depending on the underlying conditions of the market. The solution to this option exercise game provides an underlying theory from which one may begin to understand actual market behavior. Real estate development options are not always exercised in a smooth pattern; sometimes markets sit idle for years before taking off in a surge of construction. The model is able to isolate the factors which may make such a phenomenon more or less likely. In addition, sometimes these bursts of construction occur when the underlying demand for space is falling. While this is often regarded as irrational overbuilding, the model provides a rational equilibrium foundation for such exercise patterns.
JEL Classification: G13
Suggested Citation: Suggested Citation