Financial and real option analyses rely on the correct use of volatility. Determining a financial option's volatility is not a problem because it is based on the uncertainty in one variable-price, and it is projected into the future for a relatively short time. For real options, there are multiple methods to calculate volatility and there is no well-defined approach to the question of which sources of variability should be included, and for how long. Many applications use a volatility projection based on the project's life that is incorrect when the concept of actionable volatility is applied. Actionable volatility recognizes that only some and not all uncertainty is resolved when a real option is exercised. Thus this approach limits what variables are included, and for how long, in determining the project volatility parameter. Real options methods have been accused of overpricing options, and we find that traditional real option pricing methods would have dramatically overpriced options in the oil and gas sector in the past few years. Inflated volatility is the primary reason. The concept of actionable volatility limits the forecasting horizon and considers oil price reversion to the mean-both limit the value of the real option. The focus of the paper is to demonstrate a problem with the current methods of valuing real options, and an approach to correct the problem. The recent dramatic decrease in energy prices serves as another reminder that the adoption of complex mathematical models without fully understanding their underlying assumptions can lead to serious financial problems.
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