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Incorporating technical risk in compound real option models to value a pharmaceutical R&D licensing opportunity

  • Cassimon, D.
  • De Backer, M.
  • Engelen, P.J.
  • Van Wouwe, M.
  • Yordanov, V.

The valuation of multi-staged pharmaceutical R&D can be interpreted as a chain of real options. In valuing these compound option models, a crucial problem is how to deal with the different types of risk. Previous models, such as Cassimon et al. (2004), offer a closed-form solution for the valuation of a new drug development using a generalized n-fold compound option model, but implicitly bundle both commercial and technical risk in one risk measure. We extend this model by explicitly incorporating technical risk, while still preserving the closed-form solution of the model. As such, this extended model is better suited to handle real-life valuation cases in the pharmaceutical industry. We document the theoretical model with a real-life project of a major pharmaceutical multinational.

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Article provided by Elsevier in its journal Research Policy.

Volume (Year): 40 (2011)
Issue (Month): 9 ()
Pages: 1200-1216

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Handle: RePEc:eee:respol:v:40:y:2011:i:9:p:1200-1216
Contact details of provider: Web page: http://www.elsevier.com/locate/respol

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  1. 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.
  2. Robert S. Pindyck, 1992. "Investments of Uncertain Cost," NBER Working Papers 4175, National Bureau of Economic Research, Inc.
  3. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
  4. Eduardo S. Schwartz & Carlos Zozaya-Gorostiza, 2003. "Investment Under Uncertainty in Information Technology: Acquisition and Development Projects," Management Science, INFORMS, vol. 49(1), pages 57-70, January.
  5. Geske, Robert, 1979. "The valuation of compound options," Journal of Financial Economics, Elsevier, vol. 7(1), pages 63-81, March.
  6. Schwartz, Eduardo S & Moon, Mark, 2001. "Rational Pricing of Internet Companies Revisited," The Financial Review, Eastern Finance Association, vol. 36(4), pages 7-25, November.
  7. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," University of California at Los Angeles, Anderson Graduate School of Management qt43n1k4jb, Anderson Graduate School of Management, UCLA.
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