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Valuation of R&D Sequential Exchange Options Using Monte Carlo Approach

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  • Flavia Cortelezzi
  • Giovanni Villani

Abstract

This article describes a methodology for evaluating R&D investment projects using Monte Carlomethods. R&D projects generally involves multiple phases with or without overlapping. R&D investments are made often in a phased manner, with the commencement of subsequent phase being dependent on the successful completion of the preceding phase, it is known as sequential investment. Moreover, each stage creates an opportunity (option) for subsequent investment. Therefore, R&D projects can be considered as ‘Compound Options' in which investments present uncertainty both in the gross project value and in costs. It is possible to use exchange options to value the R&D investment opportunities. In this paper, we propose to value the European and American Real Compound Exchange options through Monte Carlo simulation. We also provide a set of numerical experiments to provide evidence for the accuracy of the proposed methodology.
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Suggested Citation

  • Flavia Cortelezzi & Giovanni Villani, 2009. "Valuation of R&D Sequential Exchange Options Using Monte Carlo Approach," Computational Economics, Springer;Society for Computational Economics, vol. 33(3), pages 209-236, April.
    • Handle: RePEc:kap:compec:v:33:y:2009:i:3:p:209-236
    DOI: 10.1007/s10614-008-9157-z
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    1. repec:bla:jfinan:v:43:y:1988:i:5:p:1235-56 is not listed on IDEAS
    2. Armada, Manuel Rocha & Kryzanowski, Lawrence & Pereira, Paulo Jorge, 2007. "A modified finite-lived American exchange option methodology applied to real options valuation," Global Finance Journal, Elsevier, vol. 17(3), pages 419-438, March.
    3. Geske, Robert & Johnson, Herb E, 1984. "The American Put Option Valued Analytically," Journal of Finance, American Finance Association, vol. 39(5), pages 1511-1524, December.
    4. Barraquand, Jérôme & Martineau, Didier, 1995. "Numerical Valuation of High Dimensional Multivariate American Securities," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 30(3), pages 383-405, September.
    5. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-186, March.
    6. Broadie, Mark & Glasserman, Paul, 1997. "Pricing American-style securities using simulation," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1323-1352, June.
    7. McDonald, Robert L & Siegel, Daniel R, 1985. "Investment and the Valuation of Firms When There Is an Option to Shut Down," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(2), pages 331-349, June.
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    Cited by:

    1. Giovanni Villani, 2009. "A Strategic R&D Investment with Flexible Development Time in Real Option Game Analysis," CESifo Working Paper Series 2728, CESifo.
    2. Giovanni Villani, 2014. "Valuation of R&D Investment Opportunities with the Threat of Competitors Entry in Real Option Analysis," Computational Economics, Springer;Society for Computational Economics, vol. 43(3), pages 331-355, March.
    3. Cassimon, Danny & Engelen, Peter-Jan & Yordanov, Vilimir, 2011. "Compound Real Option Valuation with Phase-Specific Volatility: a Multi-phase Mobile Payments Case Study," MPRA Paper 46053, University Library of Munich, Germany.
    4. Flavia Cortelezzi & Giovanni Villani, 2012. "Strategic R&D Investment Under Information Revelation," The Engineering Economist, Taylor & Francis Journals, vol. 57(1), pages 20-40.
    5. Giovanni Villani, 2022. "A Neural Network Approach to Value R&D Compound American Exchange Option," Computational Economics, Springer;Society for Computational Economics, vol. 60(1), pages 305-324, June.
    6. Jeon, Chanwoong & Lee, Jeongjin & Shin, Juneseuk, 2015. "Optimal subsidy estimation method using system dynamics and the real option model: Photovoltaic technology case," Applied Energy, Elsevier, vol. 142(C), pages 33-43.
    7. Pennings, Enrico & Sereno, Luigi, 2011. "Evaluating pharmaceutical R&D under technical and economic uncertainty," European Journal of Operational Research, Elsevier, vol. 212(2), pages 374-385, July.
    8. Michele Bufalo & Antonio Di Bari & Giovanni Villani, 2022. "Multi-stage real option evaluation with double barrier under stochastic volatility and interest rate," Annals of Finance, Springer, vol. 18(2), pages 247-266, June.
    9. Roger Adkins & Dean Paxson, 2017. "Sequential investments with stage-specific risks and drifts," The European Journal of Finance, Taylor & Francis Journals, vol. 23(12), pages 1150-1175, September.

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    More about this item

    Keywords

    Pseudo compound American exchange option; R&D; Monte Carlo methods; G13; O32; C15;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • O32 - Economic Development, Innovation, Technological Change, and Growth - - Innovation; Research and Development; Technological Change; Intellectual Property Rights - - - Management of Technological Innovation and R&D
    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General

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