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Understanding Market Risk and Volatility

The document discusses market risk and volatility. Volatility is measured by standard deviation and is usually expressed as an annualized daily or yearly value. Volatility can be caused by new information and trading itself. Estimating volatility involves using log returns rather than absolute returns and various approaches like historical, stochastic, and implied volatility.

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OMKAR MHETRE
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12 views8 pages

Understanding Market Risk and Volatility

The document discusses market risk and volatility. Volatility is measured by standard deviation and is usually expressed as an annualized daily or yearly value. Volatility can be caused by new information and trading itself. Estimating volatility involves using log returns rather than absolute returns and various approaches like historical, stochastic, and implied volatility.

Uploaded by

OMKAR MHETRE
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

Market Risk

Volatility
σ - standard deviation of the return provided by the variable per unit
of time when the return is expressed using continuous compounding.

What’s is unit of time ?


For Option Pricing - usually 1 year; SD of continuously compounded
return per year.

For risk management, usually 1 day; SD of continuously


compounded return per day.

2
What Causes Volatility?

New information reaching the market.

Does research support this view ?


1. The variance of the asset’s returns between the close of trading on
one day and the close of trading on the next day when there are no
intervening non-trading days.
2. The variance of the asset’s return between the close of trading on
Friday and the close of trading on Monday.

Fama (1965), French (1980), and French and Roll (1986) studies show
the second variance to be 22%, 19%, and 10.7% higher than the first
variance, respectively.

To a large extent, volatility is caused by trading itself.


3
Volatility, Variance and Time period

Stock price is 250 ; Daily volatility 2%.


Daily move in stock price = 250 × 2% = 5.
If the change in the asset price is normally distributed, 95% CI price range
would be
250 − 1.96 × 5 = 240.25 and 250 + 1.96 × 5 = 259.75
Uncertainty increases with the square root of time
10-day Volatility = Daily Volatility x = 2% x = 6.32%
10-day move in stock price = 250 × 6.32% = 15.81
95% CI price range =

4
Variance rate = Variance per day ; linear function of time
So,
Estimating Volatility

Use of log returns instead of absolute returns


 Returns are additive over time periods
 Returns over various time periods follow same probability distribution

5
Estimating Volatility - various approaches

Deterministic Stochastic Implied


Volatility Volatility Volatility

Unweighted Historical Volatility / Conditional


Moving Averages

EWMA ARCH GARCH

6
Un-weighted Historical Volatility

Where

For risk management purposes, the formula in equation is usually changed


 Mean of u is assumed to be zero. The justification for this is that the expected
change in a variable in one day is very small when compared with the standard
deviation of changes.
 m − 1 is replaced by m. This moves us from an unbiased estimate of the7
volatility to a maximum likelihood estimate
Un-weighted Historical Volatility

For risk management purposes, the formula in equation is usually changed


 Mean of u is assumed to be zero. The justification for this is that the expected
change in a variable in one day is very small when compared with the standard
deviation of changes.
 m − 1 is replaced by m. This moves us from an unbiased estimate of the
volatility to a maximum likelihood estimate

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