What is the best method to compute project volatility in Real Option Valuation?

Question

There are few methods like Copeland-Antikarov, Herath-Park, Cobb-Charnes etc. to compute project volatility, however these methods compute upward biased volatility. What is the best method I could use to compute project volatility for real option valuation?

Answer 1

There are two main approaches:

1. Comparables (depends on having an existing sample of similar project outcomes, which can be difficult to obtai [similar to historical volatility for stocks])
2. Simulation (when comparables, or rather enough of them, aren't available)

Here's a link to a paper that provides a technique for estimating volatility for real options:

http://new.vmi.edu/media/ecbu/cobb/EE4902.pdf

Generally comparables is the preferable approach in real options, provided that you have a large enough historical sample. In most cases, however simulation is used as 'true' comparables are notoriously difficult to find en masse.