6.

Volatility

6.1 Basic notions

Volatility is a measure of price variability.

1 N
Realized (historical) volatility: = [
N i 1
( ri r ) 2 1/ 2
]

1 N 2 1/ 2
RW: = [ ei ]
N i 1
Daily returns. Annualized percentage: (T/t)1/2100% T = 252.

Moving window: t =

Martingale hypothesis: t = t-1

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 6. Volatility

6.1 Basic notions (continued)

Simple moving average (SMA): t = (t + t-1 + + t-n )/n
Exponential moving average (EMA): = (1 )t-1 + t 1 , 0 < < 1
t

Initial is calculated with SMA

Exponentially weighed moving average (EWMA) truncated EMA:
t =

When n -> , EWMA -> EMA with = 2/(n + 1)

Implied volatility is based on the Black-Scholes theory.

Stochastic volatility independent process.

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SPY returns in 2009 - 2013

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 6. Volatility

6.2 Conditional heteroskedasticity (Engle & Bollerslev)

Volatility clustering (strong positive autocorrelation in squared returns):
autoregressive conditional heteroskedasticity ( ARCH(m) )
2(t) = + a12(t - 1) + a22(t - 2) + ... + am2(t - m)

Generalized ARCH ( GARCH(m, n) ):

2(t) = + a12(t - 1) + a22(t - 2) + ... + am2(t - m) +
b12(t - 1) + b22(t - 2) + ... + bn2(t - n)

GARCH(1, 1):
2(t) = + a2(t-1) + b2(t - 1) = /(1 b) +
a(2(t - 1) + b2(t - 2) + b22(t - 3) + ... ) => ARCH()

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 6. Volatility
6.2 Conditional heteroskedasticity (continued)
Unconditional expectation for GARCH(1,1): E[2(t)] = /(1 a - b)
Forecast for GARCH(1,1):
E[2(t + k)] = (a + b)k[2(t) - /(1 a - b)] + /(1 a - b)

Integrated GARCH (IGARCH): a + b = 1.

Volatility follows random walk; E[2(t + k)] = 2(t) + k
If w = 0, IGARCH has the EWMA form:
n

2(t) = (1 ) i - 1 2(t - i)
i 1
, =1b
Negative price shocks often influence volatility more than the positive
shocks => exponential GARCH (EGARCH):
log [2(t)] = + log[2(t-1)] + z(t - 1) + (|z(t 1)| - 2/ )
where z(t) = (t)/(t), > 0, and < 0.

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 6. Volatility
6.3 Realized volatility (RV)
Intraday dynamics => Brownian motion: dX = (t)dt + (t)dW
T

(t )dt
2
Integrated volatility: IV =
0

N 1
RV = ( X (t ) X (t
i 1
i i 1 )) 2 t0 = 0 < t1 < < tN-1 = T

RV -> IV as N -> ( = T/N -> 0)

If = 0 and (t) = const, RV = 2T.

Micro-noise => volatility signature: ()

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 6. Volatility

6.4 Market risk measurement

6.4.1 Sharpe ratio
Introduced in portfolio management theory but used as a trading
performance benchmark, too.
Si = (E[Ri] - Rf)/i

6.4.2 Value at risk (VaR)

Maximum amount of an asset that is likely to be lost over given time at a specific confidence level.
If the distribution of P/L is normal ( N(, ) ), then for the chosen confidence level
VaR() = -z -

Pr( Z z) = exp[-z2/2] dz = 1 -

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 6. Volatility

6.4 Market risk measurement (continued)

6.4.2 VaR (continued)
Advantages: simple and universal for entire portfolio
but...
- Determined by the model.
- Losses for given confidence level; says nothing beyond it.
- May discourage investment diversification (?):
(adding risky assets increases VaR).
- May violate risk sub-additivity rule (for non-normal
distributions):
(A + B) (A) + (B)
This may provoke investors to create separate accounts for each asset.

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 6. Volatility

6.4 Market risk measurement (continued 2)

6.4.3 Expected tail loss (ETL)
Coherent risk measures (see Dowd (2002))
(A) = (A), > 0 (homogeneity) (A) (B), if A
B (monotonicity)
(A + C) = (A) - C (translation invariance); C is risk-free asset.
(A + B) (A) + (B) (sub-additivity)

While VaR is an estimate of loss within given confidence level, ETL is an estimate of loss within
the remaining tail:
ETL = E[L | L > VaR]
For a sample of 100 P/L values and the confidence level of 95%, VaR is the sixth smallest
number in the sample while ETL is the average of the five smallest numbers within the sample.

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6. Volatility

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