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Estimating State-Dependent Volatility of Investment Projects: A Simulation Approach

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  • Pedro Godinho

    (Faculty of Economics, University of Coimbra and GEMF, Portugal)

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. In this paper I show that volatility may change not only with time but also with the state of the project. I consider two possible definitions for the project volatility, the log-variance and the variance of the project value, and I propose three procedures for estimating state-dependent volatility: two-level simulation, one and a half level simulation and a regression procedure. Computational experiments show that the one and a half level simulation procedure and the regression procedure lead to the most accurate estimations of project volatility.

Suggested Citation

  • Pedro Godinho, 2015. "Estimating State-Dependent Volatility of Investment Projects: A Simulation Approach," GEMF Working Papers 2015-02, GEMF, Faculty of Economics, University of Coimbra.
    • Handle: RePEc:gmf:wpaper:2015-02
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    References listed on IDEAS

    as
    1. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," The Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 113-147.
    2. Pedro Godinho, 2006. "Monte Carlo Estimation of Project Volatility for Real Options Analysis," GEMF Working Papers 2006-01, GEMF, Faculty of Economics, University of Coimbra.
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    More about this item

    Keywords

    Finance; Simulation; Project volatility; Real options; Investment analysis.;
    All these keywords.

    JEL classification:

    • C15 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Statistical Simulation Methods: General
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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