In successful risk management, the forecasting of volatility and correlation plays a major role.

Volatility provides important data which determines the probability of certain outcomes; this is very
essential in financial markets because it allows decision making for asset allocation and portfolio
management. Correlation and covariance are used for the pricing of equities whereas volatility is
used to price financial instruments such as options. Some VaR models use these forecasts as the
stochastic parameters.

Volatility is in reference to the degree of dispersion of the possibility outcomes of a random variable.
If it is assumed that a random variable X is normally distributed, the volatility is usually represented
by its standard deviation (Penza & Bansal, 2001:129).

Standard deviation has the advantage of providing a precise meaning when it comes to the
probability of events occurring, and it is relatively easy to scale providing that the outcomes are not
serially correlated. Assuming that there are 250 days in the working year, an example would be that
if the standard deviation is measure on a daily basis then it can be easily annualised using equation
4. Standard deviation is used widely in the financial world for the measure of volatility.

Volatility is measured (in financial economics) using the standard deviation of returns and not of
prices this is because the returns are assumed to be calculated by a stationary process with a
constant finite unconditional mean and variance (Penza & Bansal, 2001:130). Prices have an infinite
variance meaning that the variance of the price grows along with time.

There are two time series associated with correlation which is defined as the ratio of the covariance
to the product of the standard deviations of the two series; this is shown in equation 6:

Denote that both X and Y series are individually and jointly stationary. In such a case the
unconditional covariance between the two series are finite constant. Although there is the possibility
to calculate correlation from sample data, unconditional correlation cannot be measured unless the
two series are jointly stationary (Penza & Bansal, 2001:130). The annuity of correlation is not
required as it is already in a standardised form which ranges from 1 to +1. Correlation measures
short term co-movements and places little emphasis on long term co-movements.

Equally weighted moving averages

Measuring market risk with value at risk

 By Pietro Penza, Vipul K. Bansal