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A. Volatility B. Approaches To Estimating Volatility

Volatility is a measure of how much the price of an asset changes over time. It can be estimated using either implied volatility from option prices or historical volatility from past price data. Historical volatility is commonly estimated using simple variance, which equally weights all past returns, or exponentially weighted moving average (EWMA) and GARCH models, which give greater weight to more recent returns based on a smoothing parameter. These weighted models provide a better estimate of current volatility compared to simple variance.

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43 views25 pages

A. Volatility B. Approaches To Estimating Volatility

Volatility is a measure of how much the price of an asset changes over time. It can be estimated using either implied volatility from option prices or historical volatility from past price data. Historical volatility is commonly estimated using simple variance, which equally weights all past returns, or exponentially weighted moving average (EWMA) and GARCH models, which give greater weight to more recent returns based on a smoothing parameter. These weighted models provide a better estimate of current volatility compared to simple variance.

Uploaded by

Mohummed Khan Nutkani
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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A.

Volatility
B. Approaches to estimating volatility
What is Volatility
• Volatility is a statistical measure of the
tendency of a market or security to rise or fall
sharply within a period of time
• Volatility has a huge use in finance and at
a basic level is a proxy for the riskiness of an
asset.
How to measure current volatility
• Current volatility can be measured
• A. From current market prices (implied
volatility)
• B. From historical data
A. Implied Volatility
• Using black-scholes model, we can solve for
volatility
• Given the current market price, model can
generate a volatility value
• This value is implied by market price
B. Historical
• Another approach is to use historical data and
calculate volatility
• Under historical approach, volatility can be
either:
– B.1Unconditional or
– B.2 Conditional
B.1 Unconditional
• If today’s volatility does not depend upon
yesterday’s volatility, it is said to be
unconditional
• Empirical research shows that volatility is
conditional in many cases
B.2 Conditional
• Conditional volatility is more realistic
• Conditional volatility value depends to some
extent on the previous periods volatility
• Conditional volatility can be:
– B.2.1 unweighted (simple sta. Deviation)
– B.2.2 Weighted (EWMA, GARCH)
B.2.2 Weighted (EWMA, GARCH)
• These measures assign more weights to recent
data points and less weights to distant data
points
• The reason is that current volatility is more
related to recent past than to distant past
Method of calculating volatility -
Historical
• Volatility can be calculated from past data
using three most widely used methods
• 1. Simple variance method
• 2. EWMA
• 3. GARCH(x,y)
• The first step in all three method is calculate a
series of periodic returns
Calculating returns
• Daily market returns can be expressed either
in the form of percentage increase in log form

• The percentage method = U  S i  S i 1


i
• Ui = Periodic return S i 1
• Si = Today’s price
• Si-1 = Previous period’s price of a security
Continuously compounded returns
• Continously compounded returns are
expressed in log form as follows:
• ui= ln(Si / Si-1)
• Ui is expressed in continuously compounded
terms
1. Simple variance
• The most commonly used measure for
variability (volatility) in return is variance or
standard deviation
m
1
n 
2

m  1 i 1
(u n i  u ) 2

1 m
u   u n i
m i 1
1. Simple variance
• Statisticians show that the variance formula
can be reduce to the following form
1 m 2
  i 1 ui
2
n
m
• The above measure is simply the average of
the squared returns
• In calculating the variance, each squared
return is given equal weight
1. Simple variance
• So if alpha is a weight factor, then simple variance
look like

• The problem with this method is that the


yesterday return has the same weight as the last
month’s return
Weighting scheme
• Since we are interested in current level of
volatility, it makes more sense to give more
weight to recent returns
• A model that does so look like

  i 1  i un2i
2 m
n

where
m


i 1
i 1
Exponentially weighted moving average

• The problem of equal weights is fixed by the


exponentially weighted moving average (EWMA)
• More recent returns have greater weights on the
variance
• The exponentially weighted moving average
(EWMA) introduces lambda, called the smoothing
parameter
• Under that condition, instead of equal weights,
each squared return is weighted by a multiplier as
follows
The commonly used measure of lambda is 0.94. in
that case, the first (most recent) squared periodic
return is weighted by (1-0.94)(.94)0 = 6%. The
next squared return is simply a lambda-multiple
of the prior weight; in this case, 6% multiplied by
(.94)1 = 5.64%. And the third prior day’s weight
equals (1-0.94)(0.94)2= 5.30%.
• That’s the meaning of “exponential” in EWMA:
each weight is a constant multiplier of the
prior day’s weight
• This ensures a variance that is weighted or
biased toward more recent data.
• As we increase lambda, the weight of recent
returns in volatility decreases
Recency or Sample Size?
• Weighted schemes assign greater weights to
more recent data points (variances).
• Larger sample sizes are better but they require
more distant variances, which are less
relevant.
• On the other hand, if we only use recent data,
our sample size is smaller.
EWMA Model
• The weighting scheme leads us to a formula for updating
volatility estimates

  
2
n
2
n 1  (1   )u 2
n 1

• The first term shows volatility in the previous period and


the second term shows news shock of the previous
period
• Suppose there is a big move in the market variable on
day n-1, so the U2n-1 is large
• This will cause estimate of the current volatility to move
upward
Lambda
• The value of lambda governs how responsive
the estimate of the daily volatility is to the
most recent daily percentage change
• A low value of lambda leads to a great deal of
weight being given to the u2
• RiskMetrics database, created by J. P. Morgan
uses a value of lambda =0.94
The GARCH(1,1) model
The model was proposed by Bollerslev in 1986
In GARCH (1,1) we assign some weight to the
long-run average variance rate

  gV L   u
2
n
2
n 1  b 2
n 1
Since weights must sum to 1
g    b 1
• The (1,1) indicates that today's variance is
based on the most recent observation of u2
and the most recent estimate of the variance
rate
• The parameters   b are estimated
empirically for different classes of assets and
then g1   b can found out
• For a stable GARCH process, we require   b
<1. Otherwise the weight applied to the long-
term variance is negative
Setting w  gV the GARCH (1,1) model is
  w  u
2
n
2
n 1  b 2
n 1

and
w
VL 
1   b

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