Compound Real Option Valuation with Phase-Specific Volatility: A Multi-Phase Mobile Payments Case Study

Abstract

Multi-staged R&D projects are copy-book cases of compound real options. Traditional compound option models assume a constant volatility over the lifetime of the project. Building on the n-fold compound option model of Cassimon et al. (2004), we extend this model to allow for phase-specific volatility estimates, while preserving the closed-form solution of the model. We illustrate the extended model with a case study of a real option valuation of a multi-stage software application project by a large mobile phone operator and we show how project managers can estimate phase-specific volatilities.

Keywords: R&D, Real options, Compound option model, Phase-specific volatility, Mobile payments