Peter A. Brous

Valuing an Early‐Stage Biotechnology Investment as a Rainbow Option

In an article published in this journal in 2003, Richard Shockley and three of his students presented a detailed valuation of an early‐stage biotechnology investment using a binomial lattice option pricing model. The article demonstrates how investments with multiple stages can be treated as “compound sequential options” - that is, as series of options in which investments in one option provide the opportunity to invest in the next in the series. In this article, the author uses the same business case analyzed by Shockley et al. to demonstrate how to value this early-stage biotechnology investment by separately modeling the two types of risks: technology and product market. An option that has two distinct kinds of risk that develop differently over time is known as a “rainbow option.” The key adjustment to the option pricing model required to value such an option is that, instead of the standard binomial option pricing model with two outcomes at each point in time, the author uses a “quadranomial” option pricing model with four outcomes at each point in time. By distinguishing technology risks from product market risks and allowing them to develop differently over time, the authors analysis leads to a very different valuation and, indeed, a different decision about the initial investment than the one produced by Shockleys model.

Valuing “Raise Your Rate” certificates of deposit

The “Raise Your Rate�? certificate of deposit (CD) allows investors to raise the rate on their CD to the current market rate over the life of the CD. This paper presents a binomial option pricing model to value this option to raise your rate. The model also demonstrates the conditions under which the investor should choose to exercise their option and raise their rate prior to maturity. Knowing the value of this option is useful to both the bank in setting rates and investors when comparing alternative investment opportunities. The results of this model suggest that, for CDs with short maturities and low yields, the value of the option is relatively small, roughly one to four basis points, however, for CDs with longer maturities and high yields the value of the option can be as much as 30 to 70 basis points.