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Evaluating RandD projects as real options: why more variability is not always better

Author: Loch, Christoph H. ; Huchzermeier, ArndINSEAD Area: Technology and Operations Management Series: Working Paper ; 97/105/TM Publisher: Fontainebleau : INSEAD, 1997.Language: EnglishDescription: 28 p.Type of document: INSEAD Working Paper Online Access: Click here Abstract: The real options framework has been proposed as an effective tool to evaluate uncertain RandD projects because it can capture asymmetric upside potentials. We show in a simple model that established options theory understates the value of an RandD project if it does not account for corrective action that management can take during the project. The model supports intuition from options theory that variability in market payoffs increases the value of the real option. However, an increase in technical variability or in the variability of market performance requirements, without a corresponding increase in the hedging capacity or ability to respond, may reduce rather than enhance the option value, contrary to conventional options theory wisdom
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The real options framework has been proposed as an effective tool to evaluate uncertain RandD projects because it can capture asymmetric upside potentials. We show in a simple model that established options theory understates the value of an RandD project if it does not account for corrective action that management can take during the project. The model supports intuition from options theory that variability in market payoffs increases the value of the real option. However, an increase in technical variability or in the variability of market performance requirements, without a corresponding increase in the hedging capacity or ability to respond, may reduce rather than enhance the option value, contrary to conventional options theory wisdom

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