This paper shows that the presence of conditional staging in R&D (Research & Development) has a critical impact on portfolio risk, and changes diversification arguments when a portfolio is constructed. When R&D projects exhibit option-like characteristics, correlation between projects plays a more complicated role than traditional portfolio diversification would suggest. Real option theory argues that research projects with conditional phases have option-like risk and return properties, and are different from unconditional projects. We show that although the risk of a portfolio always depends on the correlation between projects, a portfolio of conditional R&D projects with real option characteristics has fundamentally different risk than a portfolio of unconditional projects. When conditional R&D projects are negatively correlated, portfolio risk is hardly reduced by diversification. When projects are positively correlated, however, diversification is more effective than these tools predict.
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Bekkum, S. van & Pennings, H.P.G. & Smit, J.T.J., 2009.
"A Real Options Perspective On R&D Portfolio Diversification,"
Research Paper
ERS-2009-019-STR Revision, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni.
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Find related papers by JEL classification: G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure O30 - Economic Development, Technological Change, and Growth - - Technological Change - - - General O32 - Economic Development, Technological Change, and Growth - - Technological Change - - - Management of Technological Innovation and R&D
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