Volatility

Chapter 9

Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
1
Autocorrelations of Daily S&P 500
Returns for Lags 1 through 100
Stylized Fact
zero autocorrelation
Are returns predictable on a daily
frequency?

In major markets, daily returns have
little autocorrelation. We can write



Returns are almost impossible to
predict from their own past.
( ) 1,2,3,... for 0 ,
1 1
= ~
+ +
t
t t t
R R Corr
Autocorrelation of Squared Daily S&P500
Returns for Lags 1 through 100
Stylized Fact
SD dominates mean
The standard deviation of returns
completely dominates the mean of
returns at short horizons such as daily.
It is typically not possible to statistically
reject a zero mean return.
Our S&P500 data has a daily mean of
0.035% and a daily standard deviation
of 1.27% (or ~20% annualized).
Stylized Fact
Variance dependence
Variance measured for example by squared
returns, displays positive correlation with its
own past.
This is most evident at short horizons such as
daily or weekly.
Figure shows the autocorrelation in squared
returns for the S&P500 data, that is


Models that can capture this variance
dependence will be presented!
t
t
small for , 0 ) , (
2
1
2
1
>
+ + t t
R R Corr
Stylized Facts
changing correlations
Correlation between assets
appears to be time varying.
Importantly, the correlation
between assets appear to
increase in highly volatile down-
markets and extremely so during
market crashes.

Definition of Volatility
Suppose that S
i
is the value of a variable on
day i. The volatility per day is the standard
deviation of ln(S
i
/S
i-1
)
Normally days when markets are closed are
ignored in volatility calculations (see Business
Snapshot 9.1, page 177)
The volatility per year is times the daily
volatility
Variance rate is the square of volatility

Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
8
252
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 2e, Chapter 9, Copyright John C. Hull 2009
9
VIX Index: A Measure of the Implied
Volatility of the S&P 500 (Figure 9.1, page
178)
Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
10
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 2e, Chapter 9, Copyright John C. Hull 2009
11
Normal and Heavy-Tailed
Distribution
Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
12
Standard Approach to Estimating
Volatility
Define o
n
as the volatility per day between
day n-1 and day n, as estimated at end of day
n-1
Define S
i
as the value of market variable at
end of day i
Define u
i
= ln(S
i
/S
i-1
)


Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
13
o
n n i
i
m
n i
i
m
m
u u
u
m
u
2 2
1
1
1
1
1
=

( )
Simplifications Usually Made in
Risk Management
Define u
i
as (S
i
S
i-1
)/S
i-1
Assume that the mean value of u
i
is zero
Replace m-1 by m

This gives

Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
14
o
n n i
i
m
m
u
2 2
1
1
=

Weighting Scheme
Instead of assigning equal weights to the
observations we can set

Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
15
o o
o
n i n i
i
m
i
i
m
u
2 2
1
1
1
=
=

=
=

where
EWMA Model (page 186)
In an exponentially weighted moving
average model, the weights assigned to
the u
2
decline exponentially as we move
back through time
This leads to

Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
16
2
1
2
1
2
) 1 (

+ o = o
n n n
u
Attractions of EWMA
Relatively little 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
RiskMetrics uses = 0.94 for daily
volatility forecasting
Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
17
GARCH (1,1), page 188
In GARCH (1,1) we assign some weight to
the long-run average variance rate



Since weights must sum to 1
+ o + | =1

Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
18
2
1
2
1
2

|o + o + = o
n n L n
u V
GARCH (1,1) continued
Setting e = V
L
the GARCH (1,1) model is


and


Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
19
| o
e
=
1
L
V
2
1
2
1
2

|o + o + e = o
n n n
u
Example
Suppose


The long-run variance rate is 0.0002 so
that the long-run volatility per day is 1.4%
Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
20
o o
n n n
u
2
1
2
1
2
0000002 013 086 = + +

. . .
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

The new volatility is 1.53% per day
Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
21
0000002 013 00001 086 0000256 000023336 . . . . . . + + =
GARCH (p,q)

Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
22
o e o | o
n i n i j
j
q
i
p
n j
u
2 2
1 1
2
= + +

= =

Other Models
Many other GARCH models have been
proposed
For example, we can design a GARCH
models so that the weight given to u
i
2

depends on whether u
i
is positive or
negative
Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
23
Variance Targeting
One way of implementing GARCH(1,1)
that increases stability is by using variance
targeting
We set the long-run average volatility
equal to the sample variance
Only two other parameters then have to be
estimated
Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
24
Maximum Likelihood Methods
In maximum likelihood methods we
choose parameters that maximize the
likelihood of the observations occurring
Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
25
Calculations for Yen Exchange
Rate Data (Table 9.4, page 192)
Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
26
Day S
i
u
i
v
i
=o
i
2
-ln v
i
-u
i
2
/v
i

1 0.007728
2 0.007779 0.006599
3 0.007746 -0.004242 0.00004355 9.6283
4 0.007816 0.009037 0.00004198 8.1329
5 0.007837 0.002687 0.00004455 9.8568
.
2423 0.008495 0.000144 0.00008417 9.3824
22063.5833
Daily Volatility of Yen: 1988-1997
Risk Management and Financial Institutions 2e, Chapter 9, Copyright John C. Hull 2009
27
Correlations
Chapter 10

Risk Management and Financial Institutions 2e, Chapter 10, Copyright John C. Hull 2009
28
Monitoring Correlation Between
Two Variables X and Y
Define x
i
=(X
i
X
i-1
)/X
i-1
and y
i
=(Y
i
Y
i-1
)/Y
i-1
Also
var
x,n
: daily variance of X calculated on day n-1
var
y,n
: daily variance of Y calculated on day n-1
cov
n
: covariance calculated on day n-1
The correlation is

n y n x
n
, ,
var var
cov
Risk Management and Financial Institutions 2e, Chapter 10, Copyright John C. Hull 2009
29
Covariance
The covariance on day n is
E(x
n
y
n
)E(x
n
)E(y
n
)
It is usually approximated as E(x
n
y
n
)

Risk Management and Financial Institutions 2e, Chapter 10, Copyright John C. Hull 2009
30
Monitoring Correlation continued
EWMA:



GARCH(1,1)


1 1 1
) 1 ( cov cov

+ =
n n n n
y x
1 1 1
cov cov

| + o + e =
n n n n
y x
Risk Management and Financial Institutions 2e, Chapter 10, Copyright John C. Hull 2009
31
Multivariate Normal Distribution
Fairly easy to handle
A variance-covariance matrix defines
the variances of and correlations
between variables
To be internally consistent a variance-
covariance matrix must be positive
semidefinite

Risk Management and Financial Institutions 2e, Chapter 10, Copyright John C. Hull 2009
32



Chapter 8
Risk Management and Financial Institutions 2e, Chapter 8, Copyright John C. Hull 2009
The VaR Measure
33
The Question Being Asked in VaR
What loss level is such that we are X%
confident it will not be exceeded in N
business days?
Risk Management and Financial Institutions 2e, Chapter 8, Copyright John C. Hull 2009
34
VaR and Regulatory Capital
Regulators base the capital they require
banks to keep on VaR
The market-risk capital is k times the 10-
day 99% VaR where k is at least 3.0
Under Basel II, capital for credit risk and
operational risk is based on a one-year
99.9% VaR

Risk Management and Financial Institutions 2e, Chapter 8, Copyright John C. Hull 2009
35
Advantages of VaR
It captures an important aspect of risk
in a single number
It is easy to understand
It asks the simple question: How bad can
things get?
Risk Management and Financial Institutions 2e, Chapter 8, Copyright John C. Hull 2009
36
VaR vs. Expected Shortfall
VaR is the loss level that will not be
exceeded with a specified probability
Expected shortfall is the expected loss
given that the loss is greater than the VaR
level (also called C-VaR and Tail Loss)
Two portfolios with the same VaR can
have very different expected shortfalls
Risk Management and Financial Institutions 2e, Chapter 8, Copyright John C. Hull 2009
37
Distributions with the Same VaR but
Different Expected Shortfalls

Risk Management and Financial Institutions 2e, Chapter 8, Copyright John C. Hull 2009
VaR
VaR
38
Normal Distribution Assumption
The simplest assumption is that daily
gains/losses are normally distributed and
independent with mean zero
It is then easy to calculate VaR from the
standard deviation (1-day VaR=2.33o)
The T-day VaR equals times the one-day
VaR
Regulators allow banks to calculate the 10 day
VaR as times the one-day VaR
T
Risk Management and Financial Institutions 2e, Chapter 8, Copyright John C. Hull 2009
10
39
Choice of VaR Parameters
Time horizon should depend on how quickly
portfolio can be unwound. Bank regulators in
effect use 1-day for market risk and 1-year for
credit/operational risk. Fund managers often
use one month
Confidence level depends on objectives.
Regulators use 99% for market risk and 99.9%
for credit/operational risk.
A bank wanting to maintain a AA credit rating will
often use confidence levels as high as 99.97%
for internal calculations.
Quiz 8.12.
Risk Management and Financial Institutions 2e, Chapter 8, Copyright John C. Hull 2009
40
Back-testing (page 169-171)
Back-testing a VaR calculation methodology involves
looking at how often exceptions (loss > VaR) occur
Alternatives: a) compare VaR with actual change in
portfolio value and b) compare VaR with change in
portfolio value assuming no change in portfolio
composition
Suppose that the theoretical probability of an exception
is p (=1X). The probability of m or more exceptions in n
days is


k n k
n
m k
p p
k n k
n

) 1 (
)! ( !
!
Risk Management and Financial Institutions 2e, Chapter 8, Copyright John C. Hull 2009
41