125.

811 Advanced Risk Analytics

Week 4: Market Risk Analytics I:

Volatility and GARCH model
Volatility

Chapter 10

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 Definition of Volatility

• Suppose that St is the price of an asset (e.g., stock)

on day t. The volatility per day is the standard
deviation of ln(St /St-1).
• Ln(St /St-1) is the logarithmic return of the asset
• Normally days when markets are closed are
ignored in volatility calculations
• Volatility per year = 252 × Volatility per day
• Variance is the square of volatility
• Volatility is denoted as 𝜎.
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 Definition of Volatility: Example

Suppose an asset price is $60 and its daily volatility

is 2%
What is a on-standard-deviation move in the asset
price over one day on average?
$60 × 0.02 = $1.2
If the change in the asset price is normally
distributed, what is the range of the asset price at
the end of the day at 95% confidence level?
95% C.I. range = $60 − 1.96 × $1.2; $60 + 1.96 × $1.2
95% C.I. range = [$57.65; $62.35]
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 Implied Volatilities
• Risk managers usually calculate volatilities from historical
data, but they also keep track of implied volatility
• Given the market price of option, one can base on the
pricing model (e.g., Black-Scholes-Merton model) to
calculate the volatility of the underlying asset, this is
called implied volatility.
• CBOE publishes VIX index, an index of the implied
volatility of 30-day options on the S&P 500.
• This can be interpreted as investors’ point of view about
volatility of S&P 500 in the next 30 days
• Further Reading: Softbank case

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VIX Index: A Measure of the Implied
Volatility of the S&P 500
90.00

80.00

70.00

60.00

50.00

40.00

30.00

20.00

10.00

0.00

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Are Daily Changes in Exchange Rates
Normally Distributed?

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

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 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 (i.e., kurtosis > 3)

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Normal and Heavy-Tailed Distribution

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 Alternatives to Normal Distributions
• In many volatility modelling, there is a need to make an
assumption about the distribution of change in asset
price (i.e., return)
• Using normal distribution is usually convenient and this
assumption may be mimic for a very large sample size
• In case the asset returns is not normally distributed (use
Jarque-Bera test with null hypothesis of jointly Skewness
= 0 and Kurtosis =3), alternatives to normal distribution
can be employed
• E.g., t-distribution, Generalized Error Distribution

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Historical approach to Estimating Volatility
• Define st as the daily volatility estimated at the
beginning of day t.
• Let say we have a window of m daily observations
which is used to estimate st
• Define Si as the value of market variable at end of
𝑆𝑖
day i. The logarithmic asset return is 𝑟𝑖 = ln( ).
𝑆𝑖−1
• The variance 𝜎𝑡2 can be calculated as:
𝑚
1
𝜎𝑡2 = ෍ 𝑟𝑡−𝑖 − 𝑟ҧ 2
𝑚−1
𝑖=1
1
• Where, 𝑟ҧ = σ𝑚
𝑖=1 𝑟𝑡−𝑖
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 Simplifications Usually Made in
Risk Management
𝑆𝑖 −𝑆𝑖−1
• The asset return is defined discretely, 𝑟𝑖 =
𝑆𝑖−1
• Assume 𝑟ҧ = 0
• Replace m−1 by m
• This gives
𝑚
1 2
𝜎𝑡2 = ෍ 𝑟𝑡−𝑖
𝑚
𝑖=1

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 Weighting Scheme
• Previous method impose same weight for each
observation (i.e., 1/m)
• However, different observations should contribute
different value of information to explain the present
• Instead of assigning equal weights to the observations
we can set
𝑚
2
𝜎𝑡2 = ෍ 𝛼𝑖 𝑟𝑡−𝑖
𝑖=1

where, σ𝑚
𝑖=1 𝛼𝑖 = 1
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 ARCH(p) Model
• If we consider only the most recent p observations
contribute to explain the current volatility, then:
𝑝 2
𝜎𝑡2 = σ𝑖=1 𝛼𝑖 𝑟𝑡−𝑖

• In an ARCH(p) model we also assign some weight to

the long-run variance rate, VL:
𝑝
2
𝜎𝑡2 = 𝛾𝑉𝐿 + ෍ 𝛼𝑖 𝑟𝑡−𝑖
𝑖=1
𝑝
σ
where, 𝛾 + 𝑖=1 𝛼𝑖 = 1.
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 ARCH(p) Model
• Let denote 𝛾𝑉𝐿 = 𝛼0 , the ARCH(p) is
𝑝
2
𝜎𝑡2 = 𝛼0 + ෍ 𝛼𝑖 𝑟𝑡−𝑖
𝑖=1
𝛼0
and, 𝑉𝐿 = 𝑝
1−σ𝑖=1 𝛼𝑖

• Long run variance rate, 𝑉𝐿 can be considered as the

average or mean of variance rate

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 EWMA Model
• In an exponentially weighted moving average
(EWMA) model, the weights assigned to the 𝑟𝑡2
decline exponentially as we move back through time

• This leads to

2 2
𝜎𝑡2 = 𝜆𝜎𝑡−1 + 1 − 𝜆 𝑟𝑡−1

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 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 over time
• l = 0.94 has been found to be a good choice across a
wide range of market variables (Risk Metrics© by
JPMorgan)

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 Generalized ARCH (1,1) – GARCH (1,1)
• In GARCH (1,1) we assign some weight to the long-
run average variance rate (𝑉𝐿 )
2 2
𝜎𝑡2 = 𝛾𝑉𝐿 + 𝛼𝑟𝑡−1 + 𝛽𝜎𝑡−1
• Since weights must sum to 1: 𝛾 + 𝛼 + 𝛽 = 1.
Weights must be positive, so, 𝛾, 𝛼, 𝛽 > 0.
• Let denote 𝜔 = 𝛾𝑉𝐿 , then GARCH(1,1) is:
2 2
𝜎𝑡2 = 𝜔 + 𝛼𝑟𝑡−1 + 𝛽𝜎𝑡−1
𝜔
and 𝑉𝐿 =
1−𝛼−𝛽

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 Generalized ARCH (1,1) – GARCH (1,1)
• 𝛼 + 𝛽 < 1 ensures GARCH(1,1) is a mean reverting
process
• This is called the weak stationary process
• 𝛼 + 𝛽 > 1 indicates that the GARCH(1,1) may not
be an appropriate model specification for the data

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 Example
• Suppose

2 2
𝜎𝑡2 = 0.000002 + 0.13𝑟𝑡−1 + 0.86𝜎𝑡−1

• The long-run variance rate is 0.0002 so that the long-

run volatility per day is 1.4%

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 Example
• Suppose that the most recent estimate of the
volatility is 1.6% per day and the most recent
percentage change in the market variable is 1%.
2
• This means 𝜎𝑡−1 = 1.6%, hence, 𝜎𝑡−1 = 0.000256
2
• 𝑟𝑡−1 = 1%, hence, 𝑟𝑡−1 = 0.0001
• 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

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 GARCH (p,q)
• GARCH (1,1) only uses the information in one last
period (e.g., one day before) to explain the current
volatility
• What if information in the last several periods (e.g.,
several days before) can be useful?
• The GARCH(p,q) can provide this generalization:
𝑝 𝑞
2 2
𝜎𝑡2 = 𝜔 + ෍ 𝛼𝑖 𝑟𝑡−𝑖 + ෍ 𝛽𝑗 𝜎𝑡−𝑗
𝑖=1 𝑗=1
𝜔
• Long term variance is: 𝑉𝐿 = 𝑝 𝑞
1−σ𝑖=1 𝛼𝑖 −σ𝑗=1 𝛽𝑗

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 Other Models
• Many other GARCH models have been proposed,
called GARCH family models
• For example, we can design a GARCH models so that
2
the weight given to 𝑟𝑡−1 depends on whether 𝑟𝑡−1 is
positive or negative
• The rationale of this extension is that bad news
normally have a greater impact on volatility
compared to good news

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 Maximum Likelihood Method
• To apply the model in practice, the question is how to
obtain the optimal values for model’s parameters,
such as 𝜔, 𝛼, 𝛽 in GARCH(1,1)?
• Ordinary Least Square (OLS) cannot be used because
the 𝜎𝑡 is not observable
• The solution is Maximum Likelihood Estimation (MLE)
• The MLE requires an assumption of the asset return
distribution to derive likelihood function of the
observations occurring
• The log of the likelihood function is then maximized to
obtain the model’s parameters
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 Maximum Likelihood Method
• Consider the normal distribution: 𝑟𝑡 ~𝑁 0, 𝜎𝑡
• Probability density function (PDF) for each
observation i is therefore:
1 𝑟𝑖2
𝑓𝑖 = exp − 2
2 2𝜎𝑖
2𝜋𝜎𝑖
• The likelihood function is the joint PDF of all
observations in the sample, that is:
𝑚
1 𝑟𝑖2
𝐿=ෑ exp − 2
2 2𝜎𝑖
𝑖=1 2𝜋𝜎
𝑖
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 Maximum Likelihood Method
• Maximizing L is equivalent with maximizing its natural
logarithm. However, the later is technically easier.
• So, ln(L) is:
𝑚
1 𝑟𝑖2
ln 𝐿 = ෍ ln exp − 2
2 2𝜎𝑖
𝑖=1 2𝜋𝜎𝑖

𝑚 2
𝑚 1 𝑟𝑖
ln 𝐿 = − ln 2𝜋 + ෍ − ln 𝜎𝑖2 − 2
2 2 𝜎𝑖
𝑖=1

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 Maximum Likelihood Method
• Log-likelihood function:
𝑚 2
𝑚 1 2 𝑟𝑖
ln 𝐿 = − ln 2𝜋 + ෍ − ln 𝜎𝑖 − 2
2 2 𝜎𝑖
𝑖=1

𝑚
• As ln 2𝜋 is a constant, ln 𝐿 is maximized when
2
𝑟𝑖2
σ𝑚
𝑖=1 − ln 𝜎𝑖2 − is maximized
𝜎𝑖2
• For GARCH (1,1), an optimal set of 𝜔, 𝛼, 𝛽 is the one
that maximizes the log-likelihood function ln 𝐿

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 S&P 500 Excel Application
• Start with trial values of parameters (l for EWMA and w, a,
and b for GARCH(1,1)
• Update variances
• Calculate
𝑚
𝑟𝑖2
෍ − ln 𝜎𝑖 − 2
𝜎𝑖
𝑖=1
• Use solver to search for values of parameters that maximize
this objective function
• For efficient operation of Solver: set up spreadsheet so that
ensure that search is over parameters that are of same order
of magnitude and test alternative starting conditions
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The GARCH Estimate of Volatility of the S&P 500
w=0.0000013465, a=0.083394, b=0.910116

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 Variance Targeting
• One way of implementing GARCH(1,1) that increases
stability is by using variance targeting
• Restrict the long-run average variance equal to the
sample variance → 𝜔 is known
• Therefore, only two other parameters (𝛼 and 𝛽) have
to be estimated

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 How Good is the Model?
• GARCH aims to capture the volatility clustering,
illustrated by the autocorrelation in 𝑟𝑡2
• Volatility clustering is a stylized fact in financial asset
returns, in which clusters of volatility are observed.
In other word, high (low) volatility tends to be
followed by high (low) volatility
• The Ljung-Box statistic tests for autocorrelation in
𝑟𝑡2
the standardized return squared,
𝜎𝑡2
• Model is sufficient if these autocorrelations are
insignificant
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 Forecasting Future Volatility
• A few lines of algebra shows that
2
𝐸[𝜎𝑡+𝑘 ] = 𝑉𝐿 + (𝛼 + 𝛽)𝑘 (𝜎𝑡2 − 𝑉𝐿 )

2
• Note that, 𝛼 + 𝛽 < 1, so if 𝑘 → ∞, 𝐸 𝜎𝑡+𝑘 → 𝑉𝐿
Example:
• Estimated GARCH (1,1) of S&P 500 in previous
example shows: w=0.0000013465, a=0.083394,
b=0.910116
• If current variance per day is 0.0003, what is the
expected variance per day in 10 days?
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 Forecasting Future Volatility
2
𝐸[𝜎𝑡+𝑘 ] = 𝑉𝐿 + (𝛼 + 𝛽)𝑘 (𝜎𝑡2 − 𝑉𝐿 )
𝜔 0.0000013465
• 𝑉𝐿 = = = 0.0002075
1−𝛼−𝛽 1−0.083394−0.910116
• 𝛼 + 𝛽 = 0.9935
2
• 𝐸 𝜎𝑡+10 = 0.0002075 + 0.993510 (0.0003 −
0.0002075) = 0.000294
• Expected variance per day in 10 days is 0.000294.
Expected volatility per day in 10 days is 0.000294
or 1.72%
• What if k=500?
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 An application to Option pricing
• One of the input parameter for the Option pricing is
the volatility per annum.
Naïve approach:
• Consider today is day t, average variance per day for
an option expiring in T days is
1 𝑇−1 2
σ𝑘=0 𝐸[𝜎𝑡+𝑘 ]
𝑇
• Convert this to variance per annum by multiplying
this by 252

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 An application to Option pricing
A more precise approach
2 1
• Set: 𝑉 𝑘 = 𝐸[𝜎𝑡+𝑘 ], and 𝑎 = ln
𝛼+𝛽
2
• 𝐸[𝜎𝑡+𝑘 ] = 𝑉𝐿 + (𝛼 + 𝛽)𝑘 (𝜎𝑡2 − 𝑉𝐿 ) will be
• 𝑉 𝑘 = 𝑉𝐿 + 𝑒 −𝑎𝑘 (𝑉 0 − 𝑉𝐿 )
• 𝑉 𝑘 is an estimate of the instantaneous variance
rate in k days

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 An application to Option pricing
• As 𝑉 𝑘 is a function of k, we can derive the average
variance per day for a future period between today and
day T using integral function:
𝑇
1 1 − 𝑒 −𝑎𝑇
න 𝑉 𝑘 𝑑𝑘 = 𝑉𝐿 + 𝑉 0 − 𝑉𝐿
𝑇 𝑎𝑇
0
• Note, 𝑇 → ∞, this converges to 𝑉𝐿
• Let 𝜎 𝑇 is the volatility per annum used to price T-day
option under GARCH(1,1)
1 − 𝑒 −𝑎𝑇
𝜎 𝑇 = 252 𝑉𝐿 + 𝑉 0 − 𝑉𝐿
𝑎𝑇
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 S&P Example
w=0.0000013465, a=0.083394, b=0.910116
1
𝑎 = ln = 0.006511
0.083394 + 0.910116
Option Life (days) 10 30 50 100 500

Est. Volatility (% 27.36 27.10 26.87 26.35 24.32

per annum)

• Volatility term structure: The relationship between the

volatilities of options and their maturities
• As a mean-reverting process, if 𝑉(0) > 𝑉𝐿 (𝑉 0 < 𝑉𝐿 ),
GARCH(1,1) estimates a downward (upward)-sloping
volatility term structure
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 Impact of Volatility Changes
• GARCH (1,1) suggests that, when calculating Vega,
we should shift the long maturity volatilities less
than the short maturity volatilities
• When instantaneous volatility changes by Ds(0),
volatility for T-day option changes by

1 − 𝑒 −𝑎𝑇 𝜎(0)
Δ𝜎(0)
𝑎𝑇 𝜎(𝑇)

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 Results for S&P 500
When instantaneous volatility changes by 1%

Option Life 10 30 50 100 500

(days)
Volatility 0.97 0.92 0.87 0.77 0.33
increase (%)

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 Application to calculate VaR
• Assume financial returns follows a normal distribution
with zero mean
• Consider today is day t. Estimated Value-at-Risk (VaR)
(in terms of percentage) tomorrow will be:
• For the 95% confidence level VaR:
𝑉𝑎𝑅𝑡+1 = −𝑧0.95 𝐸 𝜎𝑡+1 = −1.645𝐸(𝜎𝑡+1 )
• For the 99% confidence level VaR:
𝑉𝑎𝑅𝑡+1 = −𝑧0.99 𝐸 𝜎𝑡+1 = −2.33𝐸(𝜎𝑡+1 )
• 𝐸(𝜎𝑡+1 ) can be forecasted from GARCH(1,1)
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 Further reading:
Softbank case – September 2020
Source: https://www.cnbc.com/2020/09/04/softbank-reportedly-the-
nasdaq-whale-that-bought-billions-in-options.html

Original article published in Financial Times on 05 September 2020:

https://www.ft.com/content/75587aa6-1f1f-4e9d-b334-3ff866753fa2

(need to pay fee to get access to Financial Times)

Background and the story:

• Softbank Group is a Japanese conglomerate, which runs the $100

billion Vision Fund, with investments focusing on technology firms.

• Founder of the group, Masayoshi Son, “at one time considered to be

Warren Buffet of Japan”. (Bloomberg, 2020).
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 Softbank case – September 2020
• As per August 2020 filing to the Securities and Exchange
Commission (signed on 14th August 2020, reported for quarter
ended at 30th June 2020), Softbank has bought of almost $2billions
in Amazon, Alphabet, Microsoft and Tesla.

• August (alone) performance of these stocks: Tesla’s stock price ↑

74%, Apple ↑ 21%, Alphabet ↑ 10%, and Amazon ↑ 9%.

• These were among the main triggers of increasing trend in major

stock indices.

• Unusual observation: VIX index increases alongside an increase in

the stock markets.

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Softbank case – September 2020

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 Softbank case – September 2020
• VIX is implied volatility extracted from BSOP and quoted prices of
Options. Weighted prices of out-of-the-money Puts and Calls that
expire in 16 and 44 days are used.

• Investors normally refers VIX to “fear index” or “investor fear gauge”,

this is because it can represent the 30-day forward looking volatility
of stock market.

• Normally, when the investors “fear” about the future crash in stock
market, they would buy Put option to hedge. This cause an ↑ in put
option price → ↑ in VIX.

• Hence, what investors normally observe in the market is a negative

relationship between the VIX and stock price (e.g., Global Financial
Crisis or early stage of the COVID-19).

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 Softbank case – September 2020
• What happens in August 2020 is unusual since there was a positive
correlation between VIX and stock market index.

• Analysts and investors traced the money flows and see that, there
was unusually large purchases of Call options on technology stocks.

• According to Wall Street Journal, Softbank had made regulatory

filings (late August), which show that it has bought nearly $4 billion
Call options on its giant tech stock holdings. The exposure is about
$50 billion. (Link)

• Softbank is marked by the Financial Times as the “NASDAQ Whale”,

whose action of massive purchases of Call options has fueled a
significant increase in the giant tech stocks and the US stock
markets. Note: Softbank declined to comment.

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 Softbank case – September 2020
• What is the underlying mechanism of this relationship?

• Relationship: Softbank massive purchases of Call options on giant

tech stocks → ↑ in giant tech stock prices & ↑ in the VIX.

• Parties who sold call options may hedge by “Writing a covered call”
rather than naked calls. It means, they combine the long position in
giant tech stocks plus short position in call option.

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 Softbank case – September 2020
• Since the demand of those tech stocks significantly increased, their
price increased considerably.

• At the same time, massive purchases of Call options led to a

significant increase in the Calls price → ↑ VIX.

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