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Are you using simple historic volatility for your valuation of stock options and TSR-based awards? A more rigorous approach including sophisticated analysis of implied volatility could reduce the expense recognizes for stock options and TSR awards, and FAS Solutions can help.

Volatility forecasts typically rely on historical volatility and/or implied volatility. Historical volatility is the standard deviation of stock returns, which is a measure of the spread of stock returns relative to a central trend or drift. Implied volatility refers to the volatility forecast that is implied by the prices of traded options observed in the market. Implied volatility by definition is theoretically a better estimate of “expected” volatility since it is a forward-looking forecast of future volatility. However traded options typically have shorter lives than employee stock options or TSR awards. For this reason a standard “best” practice has evolved to blend historical volatility and implied volatility whenever sufficient historical and implied data exist. Still companies that grant options have to make to consider this choice carefully because of the large impact that volatility has on fair value. There is extensive research on volatility modeling with the more sophisticated models falling into three categories: Deterministic local volatility models that assume volatility is a function of the stock price level and time, but with risk factors that are not correlated with the stock. Second, continuous mean reverting stochastic volatility models, which assume that volatility is driven by a risk factor, which is likely correlated with the stock. Third, stochastic volatility models where the volatility can jump causing a discontinuity in the stock price.

Because there is no definitive proof that adding more technical sophistication and realism enhances the ability to predict volatility over the long term, FAS Solutions balances technical sophistication with common sense evidence. This includes evidence from the options market, fundamental analysis of a company’s prospective operations and financials, and industry and market trends in volatility. Our approach is consistent with the statement by FASB in its March 2004 exposure draft stated:

“An entity that uses historical share price volatility as its estimate of expected volatility without considering the extent to which future experience is reasonably expected to differ from historical experience (and the other factors cited in this paragraph) would not comply with the requirements of this Statement.”

Although most of our clients use a blend of historical volatility and implied volatility, we have developed a mean-reverting volatility model that captures some of the best forecasting characteristics of both historical and implied data resulting in a slightly improved forecast and less “volatility” in the volatility estimate.

In sum, FAS Solutions works with a client’s facts and circumstances to arrive at the best estimate of volatility. Even if a methodology seems to empirically provide a better forecast of future volatility, is it auditable and adequately reflect a client’s outlook going forward.