Offshore Petroleum Lease Evaluation under Uncertainty and Volatility Estimation Risk
16 Pages Posted: 10 Oct 2006 Last revised: 3 Dec 2008
Date Written: November 30, 2008
Abstract
Real options are now widely used in finance for the analysis of irreversible decisions under uncertainty. However, the applicability of this approach is typically limited by the fact that a key input, the volatility level, has to be approximated and estimated using only a handful of historical data or some proxy variable. This paper examines the practical implications of the resulting volatility estimation risk in finite and large samples by constructing confidence intervals for critical project values and options prices. We show that confidence intervals are asymmetric and hence investors that do not take into consideration estimation risk will tend to undertake projects precipitately. An empirical example in lease investment evaluation for an offshore petroleum tract shows that although the induced bias in the option values is likely to be small, the width of the relevant confidence interval can be substantial when a limited amount of data is used to estimate volatility.
Keywords: Real Options, Estimation Risk, Investment Evaluation, Uncertainty Aversion
JEL Classification: C44, D81, G31
Suggested Citation: Suggested Citation
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