Application of Option Games in Investment Analysis

Abstract

This paper considers a popular problem in the investment, the best time and size of investment, using methods of real options in a cooperative game setting. Moreover, it shows a combination of real option theory to invest, combined with a competitive game between two movers in the growth of a general-use asset and cooperative game theory between two movers to catch a network effect. In the model, two firms have similar and interacting investment opportunities. There is a real option for both firms to postpone the investment until they have proper price and production states. There are benefits to a first mover who can create a facility to its own conditions. Also, there is a useful network effect of operating synergy if the first mover successfully motivates the second mover to start production instantaneously by sharing the production facility. So, the first mover has to discover when to create, what capacity to create and what the best economic rent is for using the facility. The second mover has to discover whether to use the first mover’s facility or create its own facility, and if it discovers to create it owns, what better time and size are.

Keywords

• investment analysis
• uncertainty modelling
• real options analysis
• real options games
• bargaining games