The Option to Try Again: Valuing a Sequence of Dependent Trials

James Smith

Working Papers from Massachusetts Institute of Technology, Center for Energy and Environmental Policy Research

Abstract: In various fields of economic endeavor, agents enjoy the option to “try, try again.” Failure in a particular pursuit often brings renewed effort to finally succeed. Many areas of R&D could be characterized in this fashion. Our purpose is to define and measure the value of this option to try again. The value of repeated trials is closely related to the extent of statistical dependence among them. We describe the solution to this valuation problem, examine the behavior of the option premium, and characterize potential errors that are inherent in two ad hoc procedures that are often used to obtain bounds on the true value of the prospect. To be concrete, the problem is framed in terms of petroleum exploration, but the methods we employ are general and could be applied to various forms of R&D and other types of risky investments.

Date: 2004-01
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