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A Real Options Perspective on R&D Portfolio Diversification

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  • Sjoerd van Bekkum

    ()
    (Erasmus University Rotterdam)

  • Enrico Pennings

    ()
    (Erasmus University Rotterdam)

  • Han Smit

    ()
    (Erasmus University Rotterdam)

Abstract

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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Bibliographic Info

Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 08-003/2.

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Date of creation: 15 Jan 2007
Date of revision: 15 May 2009
Handle: RePEc:dgr:uvatin:20080003

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Web page: http://www.tinbergen.nl

Related research

Keywords: Real Options; Research & Development (R&D); Risk Management; Monte Carlo Simulation;

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  1. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  2. Thomke, Stefan H., 1997. "The role of flexibility in the development of new products: An empirical study," Research Policy, Elsevier, vol. 26(1), pages 105-119, March.
  3. Scherer, F. M. & Harhoff, Dietmar, 2000. "Technology policy for a world of skew-distributed outcomes," Research Policy, Elsevier, vol. 29(4-5), pages 559-566, April.
  4. Cassimon, D. & Engelen, P. J. & Thomassen, L. & Van Wouwe, M., 2004. "The valuation of a NDA using a 6-fold compound option," Research Policy, Elsevier, vol. 33(1), pages 41-51, January.
  5. Hartmann, Marcus & Hassan, Ali, 2006. "Application of real options analysis for pharmaceutical R&D project valuation--Empirical results from a survey," Research Policy, Elsevier, vol. 35(3), pages 343-354, April.
  6. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
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