Book Description

Real options refer to the investment, entry, exit and other strategic decisions of the firm that share three important characteristics: they are irreversible, they are made under uncertainty, and their timing is chosen by the firm. The term `real options' was introduced in 1977 by Stewart Myers in his paper `Determinants of corporate borrowing' that related risky debt holdings to the future investment policy of the firm. The literature on real options has since been active and growing with seminal works by Brennan and Schwartz (1985) on the valuation and optimal timing of the natural resource investments; McDonald and Siegel (1986) on general approach to investment timing and scrapping; Margrabe (1978) on the asset exchange options; Fudenberg and Tirole (1985) on the preemption and equilibrium in the technology adoption games; Pindyck (1988) on capacity choice, and Kulatilaka and Perotti (1998) on strategic growth options under imperfect competition. In the 1990's and 2000's, a number of classical textbooks in real options appeared in print: Dixit and Pindyck (1994), Trigeorgis (1996), Amram and Kulatilaka (1998), and Vollert (2003). In its development the real options literature combines the option pricing framework introduced in Black and Scholes (1973) and Merton (1973) with the research in the specific fields of economics and finance such as capital budgeting and investment policy, corporate debt and agency problems, mergers & acquisitions or game theory. The present work illustrates the application of the real options approach to three economic areas: strategic competition, mergers & acquisitions and international trade. The first chapter discusses the optimal timing of the technology adoption, entry and merger decisions in the industry producing a vertically differentiated product. I solve the model for the monopoly, duopoly and merger (which is equivalent to a monopoly with two products) and outline the equilibrium strategies of the Incumbent and the Entrant.