Can We Capture the Value of Option Volatility?

Abstract

Volatility is the one parameter that is added to information utilized in traditional discounted cash flow analysis in order to calculate the value of a real option. There is no single, theoretically justified approach for calculating the volatility coefficient for real options. This article reviews and compares the methods currently available to estimate the volatility parameter to be used in real options analysis. As these techniques often overlook the investment cost risk when estimating project volatility, a new method of computing volatility that utilizes the expected internal rate of return is presented. The methods are compared using two case studies. Furthermore, a definition of “actionable” volatility is offered in order to classify the risky parameters to be used in real options valuation. Most methods overestimate the volatility parameter, because the volatility of the decision is included in the estimate, not the volatility associated with the option, which we term actionable risk.