Size- and Leverage-Adjusting Volatility

Abstract

Volatility is an important input in the pricing of financial contracts that have option features, specifically nontraded contracts that need valuation for financial reporting or income tax reporting purposes. Often these contracts are issued by closely held companies whose shares are not traded, and thus, their value is not directly available. In this instance, the equity volatility is determined based upon a set of volatilities of guideline publicly traded companies (GPCs). These GPCs are often larger and have a different capital structure than the subject company. This article provides an up-to-date description of the current methods used to adjust the volatility for differences in size and leverage. Detailed examples are provided as well as guidance based upon our practical experience.