Valuation of R&D Sequential Exchange Options Using Monte Carlo Approach

This article describes a methodology for evaluating R&D investment projects using Monte Carlo method. R&D projects generally involve multiple phases with or without overlapping. R&D investments are made often in a phased manner, with the commencement of subsequent phase being dependent on the successful completion of the preceding phase. This is known as sequential investment. Moreover, each stage creates an opportunity (option) for subsequent investment. Therefore, R&D projects can be considered as ‘Compound Options’ in which investments present uncertainty both in the gross project value and in their costs. It is possible to use exchange options to value the R&D investment opportunities. In this paper, we propose to evaluate the European and American Real Compound exchange options through Monte Carlo simulations. We also provide a set of numerical experiments to provide evidence for the accuracy of the proposed methodology.