General Option Exercise Rules, with Applications to Embedded Options and Monopolistic Expansion

Abstract

This paper provides a general framework for pricing of real options for wide classes of payoff streams that are functions of Levy processes. As applications, we calculate the values of sequences of embedded options, (which we call Russian dolls), and study two models of expansion of a monopoly. In the first model, the monopoly increases capital stock each time the stochastic demand crosses the boundary of the inaction region. Assuming that above a certain level, the stochastic demand factor increases slower than in the standard geometric Levy models, we demonstrate that the investment threshold is lower than in the standard models. Moreover, in the intermediate range between the regimes of the fast and slow growth, the monopoly may find it optimal to simultaneously increase the capital stock and decrease the output price. In a two-factor model of technology adoption, we show that diffusion and jump uncertainty can produce opposite effects.