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NumXLTips&HintsVolatility102 1 SpiderFinancialCorp,2012

Volatility102
Thisisthesecondentryinourongoingseriesofvolatilitymodeling.Inthefirstissue,weintroducedthe
broadconceptofvolatilityinfinancialtimeseries,exploreditsgeneralcharacteristicsanddiscusseda
fewnonparametricmethodstoestimatevolatilityusinghistoricaldata.
Whyshouldyoucare?
Theconceptsdiscussedherearepivotaltoasolidunderstandingoffinancialtimeseriesvolatility.The
conceptsarenotuniquetoonemodel,butrathergenericandapplicabletotheentirevolatility
modelingdomain.
Inthisissue,westartbydefiningthevarioustermsinanassetsreturntime(e.g.holdingperiod)and
explainindetailthemultiperiodforecastofreturnsandvolatility.Next,wediscussthescalingissue
withvolatilitycomputedwithdifferentholdingperiodsandestablishacommonscalingorunitbase.
Finally,wedefinethedifferenttypesofvolatilityterms(e.g.localvolatility,termstructure,longrunand
forwardvolatility)thatwewillcomeacrossinourfuturevolatilitymodeling.
Background
Letsconsidertheassetslogreturndefinition:

1
1
1
1
ln ln ln (1 ) ln ln
t
t
t
t
t t t t t
t
S
R
S
S
r S S L S S
S

=
= = = = V

Where:
-
t
S istheclosingassetspriceatendofintervalt
-
1 t
S

istheclosingassetspriceatendofpriorinterval(t1)
- Visthefirstorderdifferenceoperator
Takingthelogreturnsisadvantageousonthreemainfronts:(1)thelogoperatorconvertsdivision
operationintosimplesubtraction,and(2)thelogtransformationdispersestherangeoverthewhole
realnumberdomain ( ) ,
t
r e ,where [ 1, )
t
R e ,andfinally,aggregatingreturnsovermulti
periodsisasimpleadditionwithlogreturns,vs.multiplicationintheregularreturnscase.

NumXLTips&HintsVolatility102 2 SpiderFinancialCorp,2012

1 2
1 1 1 1
1 2
1
1 ...
versus
...
k
t k t t t k t i
t t k
i t t t t k t i
k
t t k t t t k t i
i
S S S S S
R
S S S S S
r r r r r
+ + + + +
+
= + + +
+ + + + +
=
+ = = =
= + + + =
[


Insum,Logreturnsareeasiertoworkwithandtheyarebetterdistributedthangrossreturns.
Holdingperiod:Inourdefinitionabove,wedefinedthelogreturnoveroneperiod(samplestep).This
periodisoftenreferredtoasaholdingperiod,andwemodelthedynamicsofthereturnswiththis
particularholdingperiod.Theprobabilisticmodelforreturnswithagivenholdingperiodcanbevery
differentfromanothermodelusingadifferentholdingperiodfromthesameasset.
Also,wecanshowhowtocomputeamultiperiodreturnforecastbysimplyaggregatingthesingle
periodreturns:

1 2
1
[ ] [ ... ] [ ]
k
T T k T T T k T i
i
E r E r r r E r
+ + + + +
=
= + + + =


Whataboutahigherfrequency?Canweusemonthreturnstocomputeweekly?Thedynamicofweekly
returnsisdifferentfrommonthly(aggregate),sofromapracticalpointofviewwewouldbebetteroffto
modelweeklydata,ifpossible,ratherthanmonthly.
Whataboutmultiperiodvolatility?

1
1 2
1 1 1
Var[ ] Var[ ... ] Var[ ] 2 Cov( , )
k k k
T T k T T T k T i T i T j
i i j i
r r r r r r r

+ + + + + + +
= = = +
= + + + = +


Where:
- Cov( , )
T i T j
r r
+ +
isthecovariancebetween
T i
r
+
and
T j
r
+

Intheassetsreturnstimeseries,itisnotuncommontofindthereturnstobeseriallyuncorrelated,yet
theyaredependent(e.g.volatilityclustering).Thisoutlinesthattheinterrelationshipishigherorder
thanlinearcorrelation.
Assumingwehaveaweaksensestationary(WSS)processandreturnsarenotseriallycorrelated,then
multiperiodvariance(i.e.squaredvolatility)isexpressedasfollows:

1 2
1
Var[ ] Var[ ... ] Var[ ]
k
T T k T T T k T i
i
r r r r r
+ + + + +
=
= + + + =

NumXLTips&HintsVolatility102 3 SpiderFinancialCorp,2012

VolatilityScaling
Tocomparethevalueofsingleperiodvolatilityagainstmultiperiodvolatility,weneedaunifiedscaleor
unitbase.Inpractice,annualvolatilityisoftenimpliedwhendiscussingvalues.Thequestionnow
becomes,howdoweconvertamonthly,weeklyordailyvolatilitytoannual?
Formonthlyvolatility,wecompute12monthperiodvolatilityassumingnoserialcorrelationbetween
returns:

2 2
12
12
Y mo
Y m
o o
o o
=
=

Forweeklyvolatility,wecompute52weekperiodvolatilityassumingnoserialcorrelationbetween
individualweeklyreturns:
52
Y w
o o =
Fordailyvolatility,theholdingperiodisatradingday,sofirstwecomputethenumberoftradingdaysin
thecurrentyear(inUS, ~ 52 5 5 255 = tradingdays),andthenmultiplybythesquarerootofthis
number:
255
Y D
o o =

Local,termstructure,forwardandlongrunVolatility
Intimeseries,weoftenmentionconditional,marginalorunconditionalandlongrunvolatility.Formany
ofus,itiseasytogetthemconfused,soletsspellouttheirdefinitionsnow.
Localvolatility
Localvolatilityisanacronymforonestepconditionalvolatility,butisoftenusedwithvolatilityforecast.

1
( , , ,..., )
t t t t o
f t r r r o
+A
=
Forinstance,themovingwindowstandarddeviationdefinesnextstepvolatilityintermsofthelastm
returns.

2
1
1
( )
1
m
t i
i
t t
r r
m
o

=
+

IntheVolatilityforecastNumXLTips&Hintsissue,weconstructedanEGARCHmodeltoforecast
monthlylocalvolatilityofS&P500.Thegraphisshownbelow:

NumXLTips&HintsVolatility102 4 SpiderFinancialCorp,2012

Longrunvolatility
Oneoftheimportantcharacteristicofvolatilityinfinancialtimeseriesisthereversiontothemean
property.Thevolatilitymightgohighforaperiodoftime,thensurelycomedowntoitshistoricallevel,
oritcanbelowoveranextendedperiodoftimetogohighertoalongrunlevel.
Innotation:
lim
LR t k
k
o o

=
Longrunvolatilityiswhatisperceivedasthehistoricallevel;thisisnotthesameasthesamplestandard
deviation,anditdoesvarybasedonthemodelthatcapturesitsdynamics.
Again,inthevolatilityforecastissue,thelocalvolatilityconvergestofixedvaluesasthenumberof
forecaststeps>>1(~4.66%).Please,notethevaluesareexpressedinamonthlyunit,notannual.To
computetheannuallongrunvolatility;
4.66% 12 16.14%
A
o = =
TheS&P500hasahistoricalvolatilityaround16%perAnnum.
Nevertheless,therearenonparametricmethods(smoothingfilters)toestimatelongrunvolatility,for
instanceaBartlettkernelfilterwithwindowsizek(refertotheNumXLLRVarfunction).
Termstructure
Thetermstructureisbasicallyafunctionthatdefinesthevolatilitysvaluesfordifferentfutureholding
periods.

NumXLTips&HintsVolatility102 5 SpiderFinancialCorp,2012

Usingtoday( T )asreferencedate,thevolatilitytermstructureisdefinedasfollows:

2 2 2
2 1 1 2 1
...
( , | )
t t t t t k t k
t t k t
f t t k F
k
o o o
o
+ + + + +
+
+ + +
= + =
Notethatwedividedthesumoflocalvariancesbythenumberofperiodstopreservethescalingofthe
volatility(i.e.annualvariance).
UsingtheEGARCHvolatilityforecastforS&P500inanearlierissue(March12,2012NumXLTips&Hints
IssueVolatilityForecast),weplottedthelocalvolatilityforecastalongwithtermstructure.

Again,thevolatilityvaluesareformonthlyvolatility(i.e.notscaledtoannual).

NumXLTips&HintsVolatility102 6 SpiderFinancialCorp,2012

ForwardVolatility
Inthetermstructuredefinition,allvolatilityvaluesareforaholdingperiodfromthereferencedate
(today)andsomefuturedate.Whatifwewishtoestimatevolatilitybetweentwofuturedates?Well,
thisiswhatforwardvolatilityisabout:

( )
2 2 2
2 1 1 2 1
2 2 2 2 2 2 2
1 1 2 1 1 1 2 1
2 2 2 2
2 1 1 2 1 1
...
1
( ... ) ( ... )
( ... ) ( 1
( )
t t t t t k t k
t t k
t t k t t t t t m t m t m t m t m t m t k t k
t t t t t m t m t m t m
t t k
k
k
m k m
k m
o o o
o
o o o o o o o
o o o o o
o
+ + + + +
+
+ + + + + + + + + + + + + + +
+ + + + + + + +
+
+ + +
=
= + + + + + + +
+ + + +
= +
2 2
1 2 1
2 2
2
... )
( )
t m t m t k t k
t t m t m t k
t t k
k m
m k m
k
o
o o
o
+ + + + + +
+ + +
+
| | + +
|

\ .
+
=
Thus;

2 2
2 t t k t t m
t m t k
k m
k m
o o
o
+ +
+ +

=


Thelocal(conditional)volatilityisbasicallyaonestepforwardvolatility.
CorrelatedReturns&TimeVaryingVolatility
Letsassumewehaveatimeserieswithcorrelatedreturns.Howdowecomputemultiperiodvolatility?
Howdoweproceed?
Well,wedecomposetheasset'sreturnsintotwocomponents:

t t t
t t t
r a
r a

= +
=

Where:
-
t
istheconditionalmean(nonstochastic)
-
t
a isthestochasticshockorerrorterm( [ ] 0
t
E a = and
2 2
[ ] [ ]
t t t
Var a E a o = = )
Thus,
2
[ ] [ ]
t t t
Var r Var a o = = .

NumXLTips&HintsVolatility102 7 SpiderFinancialCorp,2012

Furthermore,thedatapointsofthe { }
t
a timeseriesarenotassumedtobeeitherindependentor
identicallydistributed.Instead, { }
t
a

observationsneedonlytobeserially(i.e.firstorder)uncorrelated.
Inshort,everythingwehavedoneearlierisstillapplicable,butusingthemeancorrected(i.e.residuals)
timeseries{ }
t
a .
Hmm..Wedontknowtheconditionalmean?Inthatcase,thingscangetabitmorecomplicated;we
needtousetwomodels:conditionalmeanandconditionalvolatilitymodels.
Wewillleavethistopicforafutureissue.
Conclusion
Inthisissue,wedidnotassumeanymodelfortheassetsreturnstimeseriesandproceededtolaythe
groundworkforvolatilitymodeling.
Furthermore,weshowedthattheabsenceofserialcorrelationintheseriesreturnsissufficientto
simplifythemultiperiodvolatilitycalculation.Thatleavesuswithjustonequestion:whatifwehavea
serialcorrelation?
Finally,wediscussedthepossibilityofaprocesswithseriallycorrelatedreturnsandavolatilitythat
variesovertime(firstandsecondorderdependency).Weareleavingthistypeofmodelingtofuture
issues.