Breakeven Volatility for Real Option Valuation

Abstract:

Financial and real options values depend on several variables, including the volatility parameter. Real option volatility arises from the uncertainty of forecasts, and thus, is more subjective than financial option volatility. Difficulties in estimating the volatility parameter inhibit confidence in the resulting option value. This article reviews current estimation methods and proposes a reverse methodology. Real options analysis determines an option value which, combined with project NPV, creates an Expanded Net Present Value (ENPV) such that ENPV exceeding zero justifies a project. At breakeven (ENPV = 0), the minimum option value that justifies the project equals NPV. This breakeven option value determines an implied breakeven volatility.

Keywords::

• Risk Management
• Decision Analysis
• Financial Engineering
• Real Options