1 Volatility estimation in Real Options with application to the oil and gas industryi

Estimating volatility for use in financial options is a pretty straight forward process as the underlying is actually a traded security. When applying financial options theory for purposes of project valuation an estimate of volatility is also required. This can be a daunting task as a project is usually not traded, making the volatility not observable in financial markets. The financial option analogy Real options rests upon an analogy between real option value levers and financial option value levers. Luehrman [1994] established a mapping between project characteristics and financial option value drivers as depicted in figure 1. Figure 1: Mapping between project and financial option drivers Financial option value levers Variable Real options value levers Exercise price X Investment cost Stock price S Present value of expected cash flows Time to expiry t Time to expiry Risk-free interest rate rf Risk-free interest rat