Volatility Estimation of Forecasted Project Returns for Real Options Analysis

Abstract

Real Options Analysis is a technique that offers advantages over the traditional Discounted Cash Flow (DCF) approach for determining project valuation. Although options analysis uses some of the same input variables used in the DCF approach, it requires one additional variable, the volatility of the project’s forecasted returns, which is notoriously difficult to estimate reliably. There are several techniques that are used to model volatility when relevant historical data from similar projects are not available. This paper reviews the nature and potential limitations of these approaches, and provides recommendations regarding the appropriate uses of the estimates resulting from these methods.