A Real Options Perspective on R&D Portfolio Diversification
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.
|Keywords||Monte Carlo simulation, real options, research and development (R&D), risk management|
|JEL||G31, Capital Budgeting; Investment Policy (jel), G32, Financing Policy; Capital and Ownership Structure (jel), O30, Technological Change; Research and Development (R&D): General (jel), O32, Management of Technological Innovation and R&D (jel)|
van Bekkum, S, Pennings, H.P.G, & Smit, J.T.J. (2008). A Real Options Perspective on R&D Portfolio Diversification (No. TI 2008-003/2). Discussion paper / Tinbergen Institute. Tinbergen Institute. Retrieved from http://hdl.handle.net/1765/10897