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.
JEL Classification: C15, G31.
Keywords: Finance; Simulation; Project volatility; Real options; Investment