Incorporating Technical Risk in Compound Real Option Models to Value a Pharmaceutical R&D Licensing Opportunity
16 Pages Posted: 12 Dec 2012 Last revised: 18 Apr 2013
Date Written: October 1, 2010
The valuation of multi-staged pharmaceutical R&D can be interpreted as a chain of real options. In valuing these compound option models, a crucial problem is how to deal with the different types of risk. Previous models, such as Cassimon et al. (2004), offer a closed-form solution for the valuation of a new drug development using a generalized n-fold compound option model, but implicitly bundle both commercial and technical risk in one risk measure. We extend this model by explicitly incorporating technical risk, while still preserving the closed-form solution of the model. As such, this extended model is better suited to handle real-life valuation cases in the pharmaceutical industry. We document the theoretical model with a real-life project of a major pharmaceutical multinational.
Keywords: Pharmaceutical R&D, Real options, Compound option model, Technical risk, Case study
JEL Classification: C6, G12, G24, G31
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