Evaluating R&D Projects with Hedging Behavior

Abstract

OVERVIEW:Many scholars suggest that, in general, successful R&D involves the systematic reduction of unique risk. Consequently, firms should adopt diversification or hedging behavior to reduce risk when investing in R&D projects. These projects can be evaluated through a real option method while considering the hedging behavior of firms. However, conventional real option methods may over- or under-state a project's value because they are apt to be influenced by the R&D firm's subjective expectations of the future market or technological prospect. The method proposed in this paper, which incorporates the hedging behavior of firms, would provide a more reasonable assessment of R&D projects, and would not be influenced by the arbitrary judgment of project evaluators. Additionally, the results imply that the effective management of investment diversification can not only reduce the unique risk faced by firms, but also enhance the value of these R&D projects.