Simulation-based estimation of state-dependent project volatility

Abstract

Project volatility is an essential parameter for real options analysis, and it may also be useful for risk analysis. Many volatility estimation procedures only consider the volatility in the first year of the project. Others consider that different years may have different values of the project volatility. This paper takes into account that volatility may change not only with time but also with the state of the project. Two possible definitions for the project volatility are considered, the log-variance and the variance of the project value, and two simulation based procedures are proposed for estimating state-dependent volatility: two-level simulation and one and a half level simulation. Computational experiments show that both the procedures perform better than the method proposed by Copeland and Antikarov, and that the one and a half level simulation procedure leads to the most accurate estimations of project volatility.