Volatility

Chapter 8

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 Definition of Volatility
 Suppose that Si is the value of a variable on
day i. The volatility per day is the standard
deviation of ln(Si /Si-1)
 Normally days when markets are closed are
ignored in volatility calculations (see Business
Snapshot 8.1)
 The volatility per year is 252 times the daily

volatility
 Variance rate is the square of volatility

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 Implied Volatilities
 Of the variables needed to price an option
the one that cannot be observed directly is
volatility
 We can therefore imply volatilities from

market prices and vice versa

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 Are Daily Changes in Exchange Rates
Normally Distributed? (Table 8.1)

Real World (%) Normal Model (%)

>1 SD 23.32 31.73
>2SD 4.67 4.55
>3SD 1.30 0.27
>4SD 0.49 0.01
>5SD 0.24 0.00
>6SD 0.13 0.00

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 Heavy Tails
 Daily exchange rate changes are not normally
distributed
 The distribution has heavier tails than the normal
distribution
 It is more peaked than the normal distribution
 This means that small changes and large
changes are more likely than the normal
distribution would suggest
 Many market variables have this property,

known as excess kurtosis

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 Normal and Heavy-Tailed
Distribution

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
Standard Approach to Estimating
Volatility
 Define sn as the volatility per day between
day n−1 and day n, as estimated at end of
day n−1
 Define S as the value of market variable at
i
end of day i
 Define u = ln(S /S )
i m i i-1
1
 
2
n 
m 1 i1
(un i  u)2

1 m
u  un i
m i1
Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 Simplifications Usually Made in
Risk Management
 Define ui as (Si−Si−1)/Si−1
 Assume that the mean value of ui is zero
 Replace m−1 by m

This gives
1 m 2
  i 1 un i
2
n
m
Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 Weighting Scheme
Instead of assigning equal weights to the
observations we can set

 i1 u
2 m 2
n i n i

where
m

 1
i1
i

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 ARCH(m) Model
In an ARCH(m) model we also assign
some weight to the long-run variance rate,
VL:

 VL i1iun2 i
2 m
n

where
m
i 1
i
1

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 EWMA Model (page 175-177)

 Inan exponentially weighted moving

average model, the weights assigned to
the u2 decline exponentially as we move
back through time
 This leads to

2 2 2
  
n n 1  (1   )u n 1

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 Attractions of EWMA
 Relativelylittle data needs to be stored
 We need only remember the current
estimate of the variance rate and the most
recent observation on the market variable
 Tracks volatility changes
 l = 0.94 has been found to be a good
choice across a wide range of market
variables

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 GARCH (1,1), page 177-179
In GARCH (1,1) we assign some weight to
the long-run average variance rate

2 2 2
  V L   u
n n 1  n 1

Since weights must sum to 1

g + a + b =1

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 GARCH (1,1) continued
Setting w = gVL the GARCH (1,1) model
is 2 2 2
 n   u n 1   n 1

and

VL 
1   

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 Example
 Suppose

  0.000002  0.13u
2
n
2
n 1  0.86 2
n 1

 The long-run variance rate is 0.0002 so

that the long-run volatility per day is 1.4%

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 Example continued
 Suppose that the current estimate of the
volatility is 1.6% per day and the most
recent percentage change in the market
variable is 1%.
 The new variance rate is

0 . 0 0 0 0 0 2  0 .1 3  0 . 0 0 0 1  0 .8 6  0 . 0 0 0 2 5 6  0 . 0 0 0 2 3 3 3 6
The new volatility is 1.53% per day

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 GARCH (p,q)

p q

   i u
2
n
2
n i   j  2
n j
i 1 j 1

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 Other Models
 Many other GARCH models have been
proposed
 For example, we can design a GARCH

models so that the weight given to ui2

depends on whether ui is positive or
negative

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023
 Maximum Likelihood Methods

 In maximum likelihood methods we

choose parameters that maximize the
likelihood of the observations occurring

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023