Volatility Estimation

&
Portfolio Optimization
Dr Arun Verma
Quantitative Research
Bloomberg, New York

Agenda
Volatility Estimation
Historical Volatility
Implied Volatility
Stochastic Volatility Models

Portfolio Optimization

Asset Allocation
Correlation Map
Tail risk measures
Diversification

09/10/2008

Buenos Aires

Straight from the LAB <GO>

BEVL Break Even Volatility

GRCH GARCH(1,1) volatility
CORM Correlation Map
CDFX CDS & FX options joint model
FFIP Fed Fund Implied probability
WIRP World Interest Rate probability
OVV (upcoming) Option valuation with a
view
OVIP (upcoming) Implied probability using
options
CPIP (upcoming) Energy and Commodity
implied probability

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Buenos Aires

Volatility : some definitions

Historical volatility :
standard deviation of the returns; measure of
uncertainty/activity
Implied volatility :
measure of the option price given by the market. Expected
Future Volatility

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Historical volatility - MERVAL

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Historical volatility - IGPA

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Historical Volatility Estimation

Textbook Method: annualized SD of xti ln

S ti
Sti1

252 n
2
(
x

x
)

ti
n 1 i =1

Better Method: subtract RN drift instead of realized drift

Textbook method slightly underestimates volatility

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Buenos Aires

Estimates based on High/Low

Commonly available information: open, close, high, low

ln S
S upper
u = ln open
S
S close
c = ln open
S

S down
d = ln open
S

Captures valuable volatility information

n
1
2
(
)
u

d
Parkinson estimate: =
t t
4 n ln 2 t =1
2
P

Garman-Klass estimate:
09/10/2008

2
GK

0.5 n
0.39 n 2
2
(ut d t )
=
ct

n t =1
n t =1

Buenos Aires

Move based estimation

MoreRogers & Satchell , Yang-Zhang indicators..

Leads to alternative historical vol estimation:

L( , T )
h ~
T

L( , T )
09/10/2008

= number of crossings of log-price over [0,T]

Buenos Aires

Bloomberg Volatility estimators

HIVG Historical Implied volatility

HVG Historical Vol with 5 estimation methods
VCMP Volatility Comparison
SKEW Implied Volatility Surface
GRCH GARCH(1,1) model volatility
BEVL Break Even Volatility

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GRCH
Standard GARCH(1,1) model
Equivalent to a discrete term stochastic
volatility model
Learns long term behavior of volatility
which standard historical volatility
calculations ignore
Compare results with historical volatility
Variance swap term structure
Credit to Prof. Engle Nobel Prize (2003,
Economics)
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GARCH Model
n2+1 = (1 ) + rn2 + n2

Continuous time equivalent is a lognormal OU process

d t2 = ( t2 )dt + t2 dW
(1 )
where =
t
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GARCH estimation
Maximum likelihood optimization
Find best value of parameters so that the
discrete walk equation has the max
likelihood as averaged over all discrete
periods
We use Matlab optimization toolbox.

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GARCH results

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Options Warm-up
P[ Red ] = 70%
P[ Black ] = 30%

Roulette:

$100 if Red
A lottery ticket gives:
$0 if Black
You can buy it or sell it for $60
Is it cheap or expensive?

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Risk Neutral Expectation

Nave expectation

70 > 60 Buy
Replication Argument

50 < 60 Sell
as if priced with other probabilities

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instead of

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Vanilla Options
European Call:
Gives the right to buy the underlying at a fixed price (the strike) at
some future time (the maturity)

Call Payoff = ( ST K ) + = max (ST K ,0)

European Put:
Gives the right to sell the underlying at a fixed strike at some maturity

Put Payoff = (K ST )

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Vanilla Options Building Blocks

Simple product, but complex mix of underlying and volatility:
Call option has :

Sensitivity to S :

Sensitivity to : Vega
These sensitivities vary through time and spot, and vol

P&L is highly path dependent

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Risk Management
Client has risk exposure
Buys a product from a bank to limit its risk
Not Enough

Risk

Too Costly

Vanilla Hedges

Perfect Hedge

Exotic Hedge

Client transfers risk to the bank which has the technology to handle it
Product fits the risk
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Modeling Uncertainty
Main ingredients for spot modeling
Many small shocks: Brownian Motion
(continuous prices) S
t

A few big shocks: Poisson process (jumps)

S

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Brownian Motion
From discrete to continuous
10
100
1000

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Black-Scholes Model
If instantaneous volatility is constant :

dS
= dt + dW
S
Then call prices are given by :
S 0 exp( rT )
1
)+ T )
K
2
T
1
S exp( rT )
1
K exp( rT ) N (
ln( 0
)
K
2
T

C BS = S 0 N (

ln(

T)

No drift in the formula, only the interest rate r due to the

hedging argument.
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Implied volatility
Input of the Black-Scholes formula which makes it fit the
market price :

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Market Skews
Dominating fact since 1987 crash: strong negative skew on
Equity Markets
impl
K

Not a general phenomenon

Gold: impl

FX: impl
K

We focus on Equity Markets

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Skews
Volatility Skew: slope of implied volatility as a
function of Strike
Link with Skewness (asymmetry) of the Risk
Neutral density function ?
Moments
1
2
3
4
09/10/2008

Statistics
Expectation
Variance
Skewness
Kurtosis

Finance
FWD price
Level of implied vol
Slope of implied vol
Convexity of implied vol

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Break Even Volatility Surface

Theoretical Skew from Prices

?
=>
Problem : How to compute option prices on an underlying without
options?
For instance : compute 3 month 5% OTM Call from price history only.
1) Discounted average of the historical Intrinsic Values.
Bad : depends on bull/bear, no call/put parity.
2) Generate paths by sampling 1 day return re-centered histogram.
Problem : CLT => converges quickly to same volatility for all
strike/maturity; breaks auto-correlation and vol/spot dependency.
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Theoretical Skew from Prices (2)

3) Discounted average of the Intrinsic Value from re-centered 3 month
histogram.
4) -Hedging : compute the implied volatility which makes the hedging a fair game.

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Theoretical Skew
from historical prices (3)
How to get a theoretical Skew just from spot price
history?
S
K
Example:
ST
3 month daily data
t
T1
T2
1 strike K = k ST1
a) price and delta hedge for a given within Black-Scholes
1

model
b) compute the associated final Profit & Loss: PL( )
k / PL k = 0
c) solve for
d) repeat a) b) c) for general time period and average
e) repeat a) b) c) and d) to get the theoretical Skew

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( )

( ( ))

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Strike dependency
Fair or Break-Even volatility is an average of returns,
weighted by the Gammas, which depend on the strike

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Strike dependency for multiple paths

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Exchange Rate: ARS Curncy BEVL

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Exchange Rate: CLP Curncy BEVL

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MERVAL Index

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IPSA (General Index)

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A Brief History of Volatility (1)

dSt = dWt Q

: Bachelier 1900

dS t
= r dt + dWt Q
St

: Black-Scholes 1973

dSt
= rt dt + (t ) dWt Q
St

dSt
= (r k ) dt + dWt Q + dq : Merton 1976
St

dSt
Q
=
+
r
dt
dW

t
t
S
t
d 2 = a(V V )dt + dZ
L
t
t

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Buenos Aires

: Merton 1973

: Hull&White 1987

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A Brief History of Volatility (2)

dS t
= t dWt Q
St

2 LT (t )
Q
d = 2
dt
+

dZ
t
T 2
2
t

dSt
= r (t ) dt + ( S , t ) dWt Q
St

C
C
+ rK
2 (K , T ) = 2 T 2 K
2 CK ,T
K
K 2
09/10/2008

Dupire 1992, arbitrage model

which fits term structure of
volatility given by log contracts.

Dupire 1993, minimal model

to fit current volatility surface

Buenos Aires

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A Brief History of Volatility (3)

dSt
S = r dt + t dWt
t
d 2 = b( 2 2 )dt + dZ

t
t
t
t

dV K ,T = K ,T dt + bK ,T dZ tQ
VK ,T

: instantane ous forward variance

conditiona l to

09/10/2008

ST = K

Heston 1993,
semi-analytical formulae.

Dupire 1996 (UTV),

Derman 1997,
stochastic volatility model
which fits current volatility
surface HJM treatment.

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A Brief History of Volatility (4)

Bates 1996, Heston + Jumps:
dSt
S = r dt + t dZ t + dq
t
d 2 = b( 2 2 )dt + dW

t
t
t
t

Local volatility + stochastic volatility:

SABR: f is a power function
dS t
= r dt + t f (S , t ) dZ tQ
St

More..Levy Processes, Stochastic Clock..

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Volatility Model Requirements

Has to fit static/current data:
Spot Price
Interest Rate Structure
Implied Volatility Surface
Should fit dynamics of:
Spot Price (Realistic Dynamics)
Volatility surface when prices move
Interest Rates (possibly)
Has to be
Understandable
In line with the actual hedge
Easy to implement

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From simple to complex

European
prices
Stochastic
Stochastic
Vol
Vol
Models
Models
Exotic prices

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Heston Model
dSt
= (r q )dt + vt dWt
St
dvt = ( vt )dt + vt dBt
dBt dWt = dt
- Calibrate Heston model to all available strikes and
maturities (relatively robust to missing strikes)
- Interpolate differences between the best-fit Heston Implied
Vols (squared) and Market Implied vols (squared).
- Flat extrapolation on errors (asymptotes are thus ShiftedHeston curves)
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Role of parameters
Correlation gives the short term skew
Mean reversion level determines the long term
value of volatility
Mean reversion strength
Determine the term structure of volatility
Dampens the skew for longer maturities

Volvol gives convexity to implied vol

Functional dependency on S has a similar effect
to correlation

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Understanding Information embedded

in Option prices: 4-way play
Underlying
Probability
density

Payoff

Implied Vol
payoff distribution

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Upcoming functions OVV & OVIP

OVIP Implied probability from Options Prices

Show Implied probabilities

Compare Historical densities to Implied densities

Illustrate Future implied paths

OVV Option valuation with a view

Draw a density of possible underlying values at a given

horizon

Draw your own payoff or choose from selected European or

structured profiles

On the fly scenario analysis and risk analysis

Use your subjective view to find an optimal portfolio for you.

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OVIP overview

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OVIP Future likely paths

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OVV Draw a subjective view

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Volatility & Correlation Map

Correlation Map
Correlation is a key data in risk management.
 Alternative way of representing covariance and
moreover effective for computation : the Vol Map.
Basic idea : construct a visual map such that:
A B 2 AB where A, B are two assets and AB
is the volatility of A/B.
cos( AB, AC ) where is the correlation of A
returns.
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Correlation Map
It is possible since AB = A B if we consider
a vectorized Black-Scholes model.
 Two similar assets will be placed close together
on the map (useful for hedging, proxy for
substitutions)
 Clusters of assets can be identified (risk
aggregation & management, hedging)
 Flat Triangles : could indicate potential arbitrage

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Geometry of random variables

Representation in risk space
n random variables represented as n points in dimension
n from the covariance matrix (of the log returns)
Standard deviation: distance
Covariance: scalar product
Correlation: cosine of the angle
X2

X1
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Visualization: Three representations

1. Raw returns (relative to USD, period 1/1/2000-1/1/2005)
Representation I : small dataset. Normalized currency pairs timeseries
1.5
AUD
EUR
GBP
JPY
MXP

1.4
1.3
1.2
1.1
1
0.9
0.8
0.7

200

400

600

800

1000

1200

1400

days

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Three representations

C =

2. Covariance matrix

0.0016 0.0003

0.0027 - 0.0017
0.0018 - 0.0009

0.0111 - 0.0008
0.0003 - 0.0017 - 0.0009 - 0.0008 0.0075

0.0106
0.0037
0.0022
0.0016

0.0037
0.0100
0.0049
0.0027

0.0022
0.0049
0.0057
0.0018

x 10
15
10
5
0
5
USD

AUD
JPY

EUR

GBP

GBP

EUR
JPY

AUD
USD

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Three representations
3. Volatility Map

NZD

0.08

AUD
0.06
0.04
0.02
CAD

0
MXP
0.02

USD
SGD
KRW

0.04

SEK
EUR
CHF

GBP

JPY

0.06
0.08
0.08 0.06 0.04 0.02

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Buenos Aires

0.02

0.04

0.06

0.08

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Correlation Map Computation

Given N assets, choose one as a base, and build the NxN
covariance matrix C of the currencies expressed in this base
Find X (for instance by Cholesky decomposition) s.t. C = X.XT
X's rows (X)i are our mapping of currencies since :

X i X iT = C (i, i )
X i X j = C (i, i ) 2 + C ( j , j ) 2 2C (i, j ) = i2 + 2j 2 ij i j
 Defines a unique simplex

Shift the origin to the barycenter of the simplex

Using implied vol data potentially builds a different map. the
implied map may not exist (Cimp<0)

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An Example

1.

Three currencies: USD, CLP, ARS (Two pairs USD-CLP, USDV yx

ARS)

V
V xx
0

V xx V xy
C =
V
yx V yy

2.

xx

= V

yx

V xx

Coordinates:
USD = (0,0) +
COP =

(V

xx

V
yx
BRL =
V
xx

V xy

V xx

V xx

V yy

V xy

V xx

JPY
CLP

, 0 +
2
Vxy
+
, V yy
Vxx

1 V yx
+ Vxx ) ,
= (
3
Vxx

09/10/2008

V yy

2
Vxy
V yy
Vxx

Buenos Aires

USD

USD

EUR

ARS

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Dimension Reduction
To represent the map, project it on a 2-3D space
Projection must minimize the loss of "information

Linear projection
PCA algorithm : keep the 2 or 3 largest eigenvalues

Non linear projection (more optimal)

minimize with respect to the (dij)

f (d ij , oij )
i< j< N
where d/o are the new/original distances
2
(
)
d

o
2
f ( d , o) = ( d o) ,
,
2
o

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A focused Latin American View

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Mix of stock indices and currencies

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MERVAL view

Banking

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IGPA index view

Banking

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Commodities view - Agriculture

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Commodities view Metals, Oil ..

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Robust Asset Allocation

and
Portfolio Optimization

BPORT <go>

PREP Portfolio Reporting

RVP
Equity Relative Value
EQS
Equity Screening
PRT
Equity Real-Time Analysis
NPH
Monitor Portfolio News
ALRT Portfolio Alerts
OSA
Monitor Equity Options
BLP Monitor Portfolios in Launchpad
BERR Portfolios on Blackberry
RSE
Analyst Research
VAR
Value-at-Risk

09/10/2008

TRK Tracking Error

WRST Stress Tests
KRR Key Rate Risk
LRSK Liquidity Risk
BBAT Equity Return Attribution
HFA Historical Fund Analysis
PFST Excel Drag & Drop
BBU Automatic Portfolio
Uploader

PRTU Create/Edit Portfolios

PLST List all Portfolios
PDIS Share Portfolios

COMING UP :
1)
ACA Asset Allocation
2)
Equity Factor Models

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Agenda
A problem at the core - Estimation risk
Risk measure choice Variance/semivariance/ CVaR?
Multi-scenario Robust optimization
Default risk
Concentration risk
Black-Litterman and beyond
Markowitz invented Mean-Variance Portfolio
Optimization in 1950s, Nobel Prize in
Economics in 1990
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Review pitfalls of Markowitz

approach
Corner Solutions
Estimation risk
Out-of-sample performance is usually bad
(Over-optimized!)
Not consistent with APT/CAPM Market
portfolio is not efficient!!

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Improving Markowitz
Approaches that work (in practice)
Assign higher variance to non-principal
factors
Adding Concentration/Liquidity risk
measures
Use Black-Litterman
Multi-scenario robust optimization
Tail risk measures
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Concentration Risk
Concentration risk can be defined as deviation
from a market/prior portfolio
( w w)T ( w w)

Conc. risk =
New optimization problem
Min (wT Cw) + (1 )(w w)T diag(C)(w w)
subjectto : wT = T
wT 1 = 1
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Data Test Bed

23 Asset classes (from Fixed income,
Equities, Commodities, International
Equities and Alternative investments)
Historical periods 1997-2007
GARCH volatilities used in place of
historical volatilities

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Concentration Risk Balance Scale

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Portfolio Optimizer Main Screen

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Output

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Efficient Frontier

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Black-Litterman Model
Use implied returns
Consistent with APT
A full version allows inputting your own
view of absolute or relative returns

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Semi-variance
Semi-variance is
defined as one-sided
quadratic risk below a
benchmark return.
Is a tractable left tail
risk measure.

09/10/2008

Buenos Aires

Var = E[(r T ) 2 ]
2

S var = E[{(r T ) } ]
E[r ]
SharpeRatio =
Var
E[r ]
SortinoRatio =
S var

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Multi-Scenario Optimization
Why put all faith in one-scenario (standard
Markowitz)?
Use historical periods as stress test
scenario
Black-Litterman view can be just another
stress test scenario
Re-sample and generate additional
scenarios
Robust Optimization framework
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Multi-Scenario Math Problem

Minimize Worst - Case Risk :
Min Maxi wT Ci w
subject to : wT i = iT , i = 1,.., N
wT 1 = 1
Optimal Portfolio may not be efficient
in any single period but only in the robust sense.
Has a great out - of - sample performance.
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Handling Default risk

Add a jump factor to each asset
In Multi-scenario framework add default
scenarios
Tail risk important in current market
scenarios

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Multi-scenario optimization

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Bad out of sample performance

(single scenario markowitz)

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Good Out of sample performance

(Concentration risk in single scenario)

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Best out of sample performance

(Multi-Scenario Optimization)

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Conclusions
Out of sample performance is a key
measure
Scenario optimization is important for a
robust framework
Portfolio and risk managers view should
be incorporated into the asset allocation
process.

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