Morgan Stanley and Infinite Equity have developed new innovative thought leadership on the development of historical volatility for purposes of ASC718. We have introduced the financial theory in the Research Brief, VWAP Volatility: ASC718 Support, and published collectively at www.VWAPVolatility.com. The intent of this Research Brief is to compare actual historical volatility calculations using both the new VWAP Volatility approach (see How to Calculate VWAP Volatility), and the traditional calculation in the marketplace of using Closing prices. In doing so, we have calculated each volatility for the S&P 500, as constituted on 1/1/2021, for various durations ranging from 3 to 10 years.
Effect on Historical Volatility Calculations
The following, Table 1, summarizes the 488 companies of the S&P 500 that have 5 years of historical data as of 12/31/2020.
Of note, VWAP volatility tends to have about a 400 basis point reduction in volatility (or about a 12% reduction in fair value).
In Table 2 below, we have summarized the Closing Volatility compared against the VWAP Volatility for varying historical lookbacks.
Of note, the change in volatility calculation does not differ materially by the period of lookback ranging from 3 years to 10 years. We have highlighted the column with a 5 year expected life, as that is an approximate estimate for what most companies use in the marketplace.
The following, Table 3, illustrates the range of reductions for the 488 companies with 5 years of historical data.
Effect on the Fair Value of Stock Options
As volatility decreases, the value of an employee stock option also decreases. The following, Table 4, is intended to illustrate the magnitude of change the VWAP Volatility creates as compared to the Closing Volatility, when ranging from 3 to 10 year lives.
We believe that the calculation of a VWAP Volatility is a refined estimate of historical volatility. Given some of the extreme volatility seen in the marketplace today due to influences like algorithmic trading, social media, the rebalancing of institutional investor portfolios, we believe that the closing price can no longer be seen as the most reliable approach for calculating historical volatility. Further, with advances in computational capabilities, we believe that the VWAP volatility should be one of the considered alternatives in selecting your process for estimating volatility.
For an estimate of how the VWAP Volatility compares to a traditional historical volatility or to know if VWAP Volatility is better for you, please reach out to your Infinite Equity consultant. Please see more research from Morgan Stanley and Technical Compensation Advisors at www.VWAPVolatility.com.