Diversification and the Value of Exploration Portfolios

34 Pages Posted: 15 Jun 2005

See all articles by James L. Smith

James L. Smith

affiliation not provided to SSRN

Rex Thompson

affiliation not provided to SSRN

Date Written: April 13, 2005

Abstract

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

Smith, James L. and Thompson, Rex W., Diversification and the Value of Exploration Portfolios (April 13, 2005). Available at SSRN: https://ssrn.com/abstract=742704 or http://dx.doi.org/10.2139/ssrn.742704

James L. Smith (Contact Author)

affiliation not provided to SSRN

Rex W. Thompson

affiliation not provided to SSRN

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