application of real options valuation to r&d investments in ...

that has occurred in the past. Depending on the asset selected as reference for theproject to be evaluated, it may be the historical volatility of a stock index of eitherpharmaceutical or biotech companies. Alternatively, one could use the volatility ofrevenues of a drug that has a similar product profile as the drug that is supposed toemerge from R&D. The historical time period chosen to define an asset‘s volatilityshould correspond to the lifetime of the option. Historical volatility ahs beensuggested by most authors as a basis for real options evaluation in the pharmaceuticalindustry, assuming that an asset‘s volatility will be driven by comparable factors in thefuture.Forecast volatility: specialist companies or experts provide forecast volatility. Thismay be the preferred approach when stock indices are used as reference for theunderlying asset.Seasonal volatility: some pharmaceutical products may have a seasonal volatility,such as influenza vaccines, or cough and cold medicines. This should be taken intoconsideration when a general volatility parameter is determined to reflect the risk ofthe product.Generally, volatility can be estimated as below.Volatility is defined as the standard deviation of the continuously compounded returnon an asset. The continuously compounded return of an asset is defined as:u t = ln (I t /I t-1 )Where:u t: return between time t-1 and tI t: asset value at time tI t-1: asset value at time t-1Volatility is then calculated based on the formula below:Page | 35