Which Came First?


You can use options to solve chicken and egg problems. Imagine you want to make a movie staring Arnold Schwarzenegger. He will agree to star in your movie if you can get the $100 million needed for financing. Assume that you could get the $100 million, but only if Arnold commits to be your star. You need Arnold to get the money, and you need the money to get Arnold, so what should you do? You could convince Arnold to give you an option on his time. He could promise to star in the movie if you pay him a certain amount. Since you would not have to pay him until you exercised the option, it would be possible to get the option before acquiring the financing. With the option in hand, you could convince the money people to trust you with the $100 million.

You can also use options to solve more complicated coordination problems. Imagine that you want to build a shopping mall. Unfortunately, five people currently own property where you want the mall to be located. You want to build the mall only if all five people agree to sell. You don’t want to start buying the land sequentially, because it would be a waste of money to get a few parcels of land if you couldn’t get them all. One solution would be to negotiate with all five owners simultaneously. This might, however, be difficult to coordinate. Another solution would be to use options. You ask each of the five owners to give you an option on their land. You might have to pay only a small amount to each landholder. If you can’t get options from everybody, you don’t exercise any of the options. This way you don’t have to buy any of the land unless you have the right to buy all of it.

Another advantage of using options is that you can back out of the deal if the mall becomes less profitable. Even if all five people agree to sell, you can choose not to exercise the option if real estate prices fall. Of course, the people giving you the options should take this into account.

For example, imagine that you own land worth $50,000. It’s worth $50,000 because next year there is a 50 percent chance that land prices will rise to $60,000 and a 50 percent chance that they will fall to $40,000. On average, the land next year will be worth $50,000. What if you give someone an option to buy your land next year for $50,000? If land prices increase, the option will probably be exercised, and you will get $50,000 for land that is worth $60,000. If land prices fall, the option will not be exercised, and you will keep the land that is worth only $40,000. Thus, if you give someone an option on your land for $50,000, then half of the time you would get $50,000, and half of the time you would keep land worth $40,000. Hence, on average, you would get only $45,000 when before you signed the option, you had land worth $50,000.




Game Theory at Work(c) How to Use Game Theory to Outthink and Outmaneuver Your Competition
Game Theory at Work(c) How to Use Game Theory to Outthink and Outmaneuver Your Competition
ISBN: N/A
EAN: N/A
Year: 2005
Pages: 260

flylib.com © 2008-2017.
If you may any questions please contact us: flylib@qtcs.net