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ACCA Strategic Professional · Advanced Financial Management · Application of option pricing theory in investment decisions

Bramwell plc is valuing a real option to delay a project. It has no traded shares on the project itself, so it needs an estimate of volatility. Which approach to estimating the volatility input is most consistent with AFM study material?

Volatility for a real option is usually estimated from the share price returns of listed companies engaged in similar business, used as a proxy for the project's value volatility. Cost of equity and the risk-free rate are different inputs and do not measure variability.

  1. AUse the standard deviation of the share returns of listed companies whose business is similar to the project, as a proxy for the volatility of the underlying project valueCorrect
  2. BUse the company's own cost of equity as the volatility input
  3. CUse the risk-free rate as the volatility input because the option is risk-free
  4. DUse the standard deviation of the project's initial capital outlay

Explanation

Real options on projects have no traded price, so volatility is normally proxied by the share price volatility of quoted firms in the same industry, or by simulation of project value. A cost of equity is a required return, not a measure of dispersion. The risk-free rate is a separate Black-Scholes input.

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