How to estimate volatility?

Some respondents suggested to require all entities to use the same expected volatility, but FASB believes that mandating the same estimate of expected volatility for use by all entities would impair, rather than improve, comparability because the volatilities of different entities differ.  The use of minimum value by nonpublic entities is a practical solution to the difficulties of estimating expected volatility for a nonpublic entity.  For a public entity, estimating the fair value of its options is practicable because an estimate of expected volatility can be made.  (See FAS123, Par. 178)   

Per FAS 123 (R), A31, an entity's estimate of expected volatility should be reasonable and supportable. Factors to consider in estimating expected volatility includes:

1. Volatility of the share price, including changes in that volatility and possible mean reversion of that volatility, over the most recent period that is generally commensurate with (1) the contractual term of the option if a lattice model is being used to estimate fair value or (2) the expected term of the option if a closed-form model is being used. For example, in computing historical volatility, an entity might disregard an identifiable period of time in which its share price was extraordinarily volatile because of a failed takeover bid if a similar event is not expected to recur during the expected or contractual term. If an entity's share price was extremely volatile for an identifiable period of time, for instance, due to a general market decline, that entity might place less weight on its volatility during that period of time because of possible mean reversion.
2. The implied volatility of the share price determined from the market prices of traded options or other traded financial instruments such as outstanding convertible debt, if any.
3. For public companies, the length of time an entity's shares have been publicly traded. If that period is shorter than the expected or contractual term of the option, the term structure of volatility for the longest period for which trading activity is available should be more relevant. A newly public entity also might consider the expected volatility of similar entities. A nonpublic entity might base its expected volatility on the expected volatilities of entities that are similar except for having publicly traded securities.
4. Appropriate and regular intervals for price observations. If an entity considers historical volatility in estimating expected volatility, it should use intervals that are appropriate based on the facts and circumstances and that provide the basis for a reasonable fair value estimate. For example, a publicly traded entity would likely use daily price observations, while a nonpublic entity with shares that occasionally change hands at negotiated prices might use monthly price observations.
5. Corporate and capital structure. An entity's corporate structure may affect expected volatility (paragraph A21). An entity's capital structure also may affect expected volatility; for example, highly leveraged entities tend to have higher volatilities.

FAS 123 (R) does not prescribe a method to estimate expected volatility, but does describe in paragraph A32 certain factors to "consider" in estimating expected volatility:

• Historical stock-price volatility.
• Historical and current implied volatilities.
• Changes in corporate and capital structure.
• Limitations on availability of historical data.
• Guideline companies.
• Historical data intervals.
• Weighting of items for consideration.

Historical volatility can be automatically calculated by using “Option123 (Excel), v. 6.0", once the expected life of options is defined. 

	Historical volatility calculated by using our software	Volatility as reported on 10 K
		2000	1999	1998
From Fortune 100
General Motors	29.8805%	27.80%	27.90%	32.80%
Microsoft	35.0743%	32.00%	32.00%	33.00%
Dell Computer	57.7546%	51.03%	52.12%	54.92%
Yahoo	73.9543%	76.00%	71.00%	67.00%
Exxon Mobil	20.3816%	16.00%	15.00%	13.00%
Citicorp	36.2232%	42.03%	40.60%	38.80%
ATT	33.9982%	28.30%	23.80%	21.80%
AOL	63.3848%	46.30%	65.00%	65.00%
IBM	32.1364%	32.00%	27.30%	26.40%
Philip Morris	32.5852%	31.73%	26.06%	23.83%
Correlation coefficient		0.94	0.98	0.96
	Historical volatility calculated by using our software	Volatility as reported on 10 K
		2000	1999	1998
Randomly Picked on Wall Street Journal
Applied Micro Inc	93.6232%	82.00%	89.00%	92.00%
Cisco Systems Inc	44.5740%	33.90%	40.20%	35.60%
Rational Software Inc.	79.3290%	76.00%	72.00%	60.00%
Sun Microsys	53.0299%	52.05%	49.51%	49.60%
Rambus Inc.	96.2911%	98.00%	82.00%	82.00%
Siebel Systems Inc.	75.0210%	77.00%	69.00%	70.50%
Broadcom Corp	87.9835%	90.00%	80.00%	74.00%
Apple Computer Inc.	63.8612%	67.00%	55.00%	78.00%
eBay Inc.	109.4280%	115.00%	100.00%	80.00%
Vignette Corp	132.6490%	140.00%	120.00%	--
Correlation coefficient		0.98	0.99	0.81