Volatility estimation for stochastic project value models

Consolidation of multiple sources of uncertainty into a single stochastic process for project value can provide increased computational flexibility for the analysis of complex real option valuation problems. Nonetheless, the volatility, a critical parameter in the stochastic project value model, is systematically overstated by the existing estimation methods, which can result in incorrect option values. Several recently published works have discussed examples that illustrate this issue numerically, and have developed the rationale for addressing the root problem and provided revised estimation methods. In this article, we extend that work by first analytically proving both the source of the bias and the adjustment to remove it, and then by generalizing for the cases of levered cash flows and non-constant volatility. In each case, we show how a revised estimation methodology can be applied with example problems. 1 Corresponding author: Warren J. Hahn, Pepperdine University, 24255 Pacific Coast Highway, Malibu, California 90263; Tel. +1 310 506 8542; Fax: +1 310 506 4126; E-mail address: [email protected]