What is Expected Volatility?
Expected volatility is a key input to option pricing models, representing the assumed standard deviation of the underlying share’s continuously compounded returns over the option’s life. It is one of the few inputs an entity must estimate, since it cannot be observed directly.
How It Works
- Compute historical volatility from recent share price data.
- Adjust for any expected structural changes in the business.
- Cross-check against implied volatility on traded options if available.
- Document the rationale for the chosen rate.
Saudi Context
Saudi entities granting employee options often rely on historical Tadawul volatility for similar peer stocks when their own shares are not traded or have limited history.
Example
If a share’s annualized historical volatility over the past three years is 28 percent, the entity may use 28 percent as expected volatility in a Black-Scholes model.