Separating ambiguity and volatility in cash flow simulation based volatility estimation

Volatility is a significant parameter both in financial and real options valuation. However, in the case of several real option projects there is no historical data available. In such cases, one alternative is to use Monte Carlo simulation on projects’ cash flows for volatility estimation. An important issue that has not been taken into account with most of these volatility simulation procedures is that not only the volatility but also the value of the underlying asset is often uncertain with ambiguity in the beginning. Because most of the existing methods do not take this into account, they overestimate the actual volatility of the project. This paper presents a procedure that separates the underlying asset uncertainty in the beginning from the volatility and hence improves the volatility estimation.