Valuation of R&D compound option using Markov chain approach

• Published in: Annals of finance Vol. 17; no. 3; pp. 379 - 404
• Main Authors: D’Amico, Guglielmo, Villani, Giovanni
• Format: Journal Article
• Language: English
• Published: Berlin/Heidelberg Springer Berlin Heidelberg 01.09.2021; Springer Nature B.V
• Subjects: Economic Theory/Quantitative Economics/Mathematical Methods; Economics and Finance; Finance; Macroeconomics/Monetary Economics//Financial Economics; Pharmaceuticals; Quantitative Finance; Research Article; Valuation; Compound option; C02; Technical risk; G11; Real option
• ISSN: 1614-2446; 1614-2454
• DOI: 10.1007/s10436-021-00389-1

Incorporation of technical risk in compound real options has been considered in Cassimon et al. ( 2011 ) concerning the valuation of multi-stage pharmaceutical R&D. There, the technical success probabilities at each development stage were assumed to be generated independently of each other. This assumption can be unrealistic in many applied problems, pharmaceutical R&D included. We present a valuation procedure dealing with dependent success probabilities and random development stage times. This greater flexibility allows a better description of the sequence of decision stages and results, which in turn, impact the value of the considered project. The theoretical results are illustrated through a numerical example that shows the implementation of the model to a pharmaceutical R&D problem.