This study sets up a compound option approach for evaluating pharmaceutical R&D investment projects in the presence of technical and economic uncertainties. Technical uncertainty is modeled as a Poisson jump that allows for failure and thus abandonment of the drug development. Economic uncertainty is modeled as a standard diffusion process which incorporates both up-and downward shocks. Practical application of this method is emphasized through a case analysis. We show that both uncertainties have a positive impact on the R&D option value. Moreover, from the sensitivity analysis, we find that the sensitivity of the option with respect to economic uncertainty and market introduction cost decreases when technical uncertainty increases.

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Keywords R&D, compound option, jump-diffusion process, pharmaceutical industry
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Series ERIM Top-Core Articles
Journal European Journal of Operational Research
Pennings, H.P.G, & Sereno, L. (2011). Evaluating pharmaceutical R&D under technical and economic uncertainty. European Journal of Operational Research, 212(2), 374–385. doi:10.1016/j.ejor.2011.01.055