Managing Risks in Multiple Online Auctions: An Options Approach*

ABSTRACT

The scenario of established business sellers utilizing online auction markets to reach consumers and sell new products is becoming increasingly common. We propose a class of risk management tools, loosely based on the concept of financial options that can be employed by such sellers. While conceptually similar to options in financial markets, we empirically demonstrate that option instruments within auction markets cannot be developed employing similar methodologies, because the fundamental tenets of extant option pricing models do not hold within online auction markets. We provide a framework to analyze the value proposition of options to potential sellers, option-holder behavior implications on auction processes, and seller strategies to write and price options that maximize potential revenues. We then develop an approach that enables a seller to assess the demand for options under different option price and volume scenarios. We compare option prices derived from our approach with those derived from the Black-Scholes model (Black & Scholes, 1973) and discuss the implications of the price differences. Experiments based on actual auction data suggest that options can provide significant benefits under a variety of option-holder behavioral patterns.