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Rational Plunging and the Option Value of Sequential Investment The Case of Petroleum Exploration

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Author Info
James L. Smith
Rex Thompson

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Abstract

Any investor in assets that can be exploited sequentially faces a tradeoff between diversification and concentration. Loading a portfolio with correlated assets has the potential to inflate variance, but also creates information spillovers and real options that may augment total return and mitigate variance. The task of optimal portfolio design is therefore to strike an appropriate balance between diversification and concentration. We examine this tradeoff in the context of petroleum exploration. Using a simple model of geological dependence, we show that the value of learning options creates incentives for explorationists to plunge into dependence; i.e., to assemble portfolios of highly correlated exploration prospects. Risk-neutral and risk-averse investors are distinguished not by the plunging phenomenon, but by the threshold level of dependence that triggers such behavior. Aversion to risk does not imply aversion to dependence. Indeed the potential to plunge may be larger for risk-averse investors than for risk-neutral investors. To test the empirical validity of our theory, we examine the concentration of bids tendered in petroleum lease sales. We find that higher levels of risk aversion are associated with a revealed preference for more highly concentrated (i.e., less diversified) portfolios.

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Paper provided by Massachusetts Institute of Technology, Center for Energy and Environmental Policy Research in its series Working Papers with number 0602.

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Date of creation: Feb 2006
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Handle: RePEc:mee:wpaper:0602

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  1. Lawrence M. Benveniste & Alexander Ljungqvist & William J. Wilhelm & Xiaoyun Yu, 2003. "Evidence of Information Spillovers in the Production of Investment Banking Services," Journal of Finance, American Finance Association, vol. 58(2), pages 577-608, 04. [Downloadable!] (restricted)
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  2. Roberts, Kevin & Weitzman, Martin L, 1981. "Funding Criteria for Research, Development, and Exploration Projects," Econometrica, Econometric Society, vol. 49(5), pages 1261-88, September. [Downloadable!] (restricted)
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  3. Rainer Brosch, 2001. "Portfolio-aspects in real options management," Working Paper Series: Finance and Accounting 66, Department of Finance, Goethe University Frankfurt am Main. [Downloadable!]
  4. Gilbert, Richard J, 1979. "Optimal Depletion of an Uncertain Stock," Review of Economic Studies, Blackwell Publishing, vol. 46(1), pages 47-57, January. [Downloadable!] (restricted)
  5. Paddock, James L & Siegel, Daniel R & Smith, James L, 1988. "Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 479-508, August. [Downloadable!] (restricted)
  6. Thijssen, J.J.J. & Huisman, K.J.M. & Kort, P.M., 2001. "Strategic investment under uncertainty and information spillovers," Discussion Paper 91, Tilburg University, Center for Economic Research. [Downloadable!]
  7. Grenadier, Steven R, 1999. "Information Revelation through Option Exercise," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 12(1), pages 95-129.
  8. Kaufman, Gordon M. & Mattar, Mahdi, 2003. "Private Risk," Working papers 4316-03, Massachusetts Institute of Technology (MIT), Sloan School of Management. [Downloadable!]
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