How is the expected volatility of the stock price estimated?

Expected volatility represents a measure of the amount that the share price is expected to fluctuate during a period. (e.g., the higher the volatility, the more returns on shares can be expected to vary - up or down). When estimating expected volatility, a company needs to consider several factors including:

• Using historical volatility only as starting point and considering ways in which future volatility may differ from historical.
• Discounting historical volatility in periods attributable to non-routine transactions. (e.g., taking into consideration volatility due to rare events not expected to occur again - such as a failed takeover bid)¹.
• Using "implied volatility" based on the market value of traded options, that may indicate how future volatility would differ from historical volatility.
• For public companies, the length of time that shares have been publicly traded.
• For newly public or private companies, the expected volatility of similar entities².
• Intervals for price observations. (e.g., public companies would typically use daily price observations unless their stock is thinly traded; while private companies might use weekly or monthly observations).
• Corporate and capital structure. (e.g., highly leveraged companies would tend to have higher volatility).

Lattice models allow for an expected range of volatility over the option's expected term while closed-form models do not. This is obviously a matter of judgment to be applied by the company in determining which model to use and how best to incorporate expected volatility within the model chosen. Either way, the process for estimating expected volatility should be applied consistently.

² Expected volatility may be based on a group of companies that are comparable to the entity. To find comparable public companies, consider a disclosure search on www.sec.gov within a particular Standard Industrial Classification (SIC). Factors to consider in judging comparability include industry, stage of life cycle, size and financial leverage. Industry sector indices should be avoided, since the effects of diversification that are inherent in the index make it less useful than the trading history of comparable individual companies. Closely-held companies should review the constituent companies included in indices and incorporate the same factors for comparability listed previously.

Continue Reading - How is the expected term of the options estimated?

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