Diversification and the Value of Exploration Portfolios
34 Pages Posted: 15 Jun 2005
Date Written: April 13, 2005
Conventional wisdom holds that dependence among geological prospects increases exploration risk. However, dependence also creates the option to truncate exploration if early results are discouraging. We show that the value of this option creates incentives for explorationists to plunge into dependence; i.e., to assemble portfolios of highly correlated exploration prospects. Risk-neutral and risk-averse investors are distinguished not by the plunging phenomenon, but by the threshold level of dependence that triggers such behavior. Aversion to risk does not imply aversion to dependence. Indeed the potential to plunge may be larger for risk-averse investors than for risk-neutral investors.
Keywords: Diversification, exploration risk, real options, portfolio valuation
JEL Classification: D83, G11, G31, L71
Suggested Citation: Suggested Citation