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VOLATILITY MODELLING

What Is Volatility?
Volatility is a statistical measure of the  dispersion of returns for a given security or market index.

In most cases, the higher the volatility, the riskier the security.

Volatility is often measured as either the standard deviation or variance between returns from that

same security or market index.

Volatility is often calculated using variance and standard deviation.

The standard deviation is the square root of the variance. 

Hence, Volatility is a statistical measure of the dispersion of price for a given security or market
index.

CHARACTERISTICS OF VOLATILITY

A special feature of stock volatility is that it is not directly observable.

For example, consider the daily log returns of any stock. The daily volatility is not directly observable
from the return data because there is only one observation in a trading day. If intraday data of the
stock, such as 10-minute returns, are available, then one can estimate the daily volatility

For example, stock volatility consists of intraday volatility and overnight volatility with the latter
denoting variation between trading days.

The high-frequency intraday returns contain only very limited information about the overnight
volatility.

The unobservability of volatility makes it difficult to evaluate the forecasting performance of

conditional heteroscedastic models.

Types of Volatility-

1. Actual Historical volatility (Realized Volatility) –

Historic Volatility is the statistical volatility, or the measured historic price volatility of the
underlying security.
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It is the “known volatility” because it is based on actual price changes in the underlying in

the past.
Also known as realized volatility, it is calculated as the square root of the realized variance,
and realized variance is calculated using the sum of squared returns divided by the number
of observations.

2. Actual Future Volatility –

Volatility over a period starting at the current time and ending at a future date . This is the
future volatility - the projection of the volatility.

This is used mainly in case of the options – and this future date is the date of expiry of the
options.

3. Implied Volatility –
Volatility observed from historical prices of options.
Implied volatility is also future volatility calculated using only historical options prices.

4. Stochastic Volatility –
Stochastic volatility is a concept that says- that any price volatility varies over time and it is
not constant.
Examples of stochastic models include the GARCH model used in analysing time-series data
where the variance error is believed to be serially correlated (autocorrelated).

Relevance of Volatility

1. The wider the swings in an investment's price, the harder emotionally it is to not worry.
-wider swings in investment price ,more is the worry
2. Price volatility of a trading instrument can define position sizing in a portfolio.
3. When certain cash flows from selling a security are needed at a specific future date, higher
volatility means a greater chance of a shortfall.
4. Higher volatility of returns while saving for retirement results in a wider distribution of
possible final portfolio values.
5. Higher volatility of return, when retired, gives withdrawals a larger permanent impact on the
portfolio's value.
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6. Price volatility presents opportunities to buy assets cheaply and sell when overpriced.
7. Highers volatility of securities give better opportunities to daily traders.
8. Portfolio volatility has a negative impact on the Compounded Annual Growth Rate (CAGR) of
that portfolio.
9. Volatility affects pricing of Options, being a parameter of the Black-Scholes model.
Volatility versus direction

Volatility does not measure the direction of price changes data, - it only measures the dispersion.
Mathematically - This happens because when we are calculating standard deviation (or variance), all
differences are squared, so that negative and positive differences are combined into one absolute
value. Hence, it will only give you the magnitude of variance.

Sample Variance

Variance tells you the degree of spread in your data set. The more spread the data, the larger the
variance is in relation to the mean. Variance and standard deviation are widely used measures of
dispersion of data or, in finance and investing, measures of volatility of asset prices.

The primary task of inferential statistics (or estimating or forecasting) is making an opinion about
something by using only an incomplete sample of data.

In statistics it is very important to distinguish between population and sample. A population is

defined as all members (e.g. occurrences, prices, annual returns) of a specified group.

Population is the whole group. A sample is a part of a population that is used to describe the
characteristics (e.g. mean or standard deviation) of the whole population. The size of a sample can
be less than 1%, or 10%, or 60% of the population, but it is never the whole population.

When calculating variance and standard deviation, it is important to know whether we are
calculating them for the whole population using all the data, or we are calculation them using only a
sample of data. In the first case we call them ‘population variance’ and ‘population standard
deviation’. In the second case we call them ‘sample variance’ and ‘sample standard deviation’.

The variance is mathematically defined as the average of the squared differences from the mean.
For Volatility estimation, the sample variance (denoted as s2), can be used to figure out the standard
deviation (s), which is the said volatility of that time series.
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Population variance (σ2) = Σ(xi - µ)2 µ = population mean

N N = number of observations

Sample variance (s2) = Σ(xi - x̄)2 x̄ = sample mean

n-1 n = number of observations

Proxy for volatility- Squared Returns

While modelling for volatility, in place of Sum of squared differences – we can also use the sum of
squared returns.

Sum of squared differences= sum of squared returns.

Squared returns is the daily variances of the time series of stock closing prices.

Mathematically, while dealing with the series of returns, this is derived from the formula of the

variance as we can assume the long run mean (µ) to be zero for any data of stock returns.

Calculating Realized (Historical) Volatility

Using the Sample variance formula with Squared deviations:

1. Firstly, gather daily stock price returns and then determine the mean of the returns.
2. Next, compute the difference between each day’s return and the mean price.
3. Next, compute the square of all the deviations.
4. Next, find the summation of all the squared deviations.
5. Next, divide the summation of all the squared deviations by the number of values-1, say m-1.
It is called the variance of the stock price.
6. Next, compute the daily volatility or standard deviation by calculating the square root of the
variance of the stock.
7. Next, the annualized volatility formula is calculated by multiplying the daily volatility by the
square root of 248. Here, 248 is the assumed number of trading days in a year.
Or using the squared returns, simply replace the sum of squared differences by the sum of squared
returns.
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Unconditional and Conditional Forecasting (of Volatility)

Unconditional volatility is the "general" volatility of a random variable when there is no extra

information (no conditioning).

Conditional volatility is the volatility of a random variable given (i.e., conditioning on) some extra
information.

E.g., in the ARCH model the conditional volatility is conditioned on past values of itself.

While the unconditional variance is just the standard measure of the variance,

the conditional variance represents the measure of the uncertainty about a variable given a model
and an information set.

Unconditional volatility- can be described as a mean of the volatility for an observed period.
Whereas, Conditional forecast method takes into account the information available at each time
period. The name ‘Conditional’ refers to the fact that the estimation is conditional on knowing
yesterday’s volatility.

We cannot predict unconditional volatility

AutoRegressive Conditional Heteroskedasticity (ARCH) Model

 ARCH – AutoRegressive Conditional Heteroskedasticity

 Estimate risk

 AutoRegressive – heteroskedasticity present in different time periods may be

autocorrelated—n past values effects future values

 Conditional – Variance is based on past values, it is not constant

 Heteroskedasticity – series has changing variance

ARCH (q): 𝜎𝑡2 = 𝛼0 + 𝛼1𝑢𝑡−12 + 𝛼2𝑢𝑡−2 2 +. . . +𝛼𝑞𝑢𝑡−q2

 All values are squared—variance—returns
 Alpha 1 is affecting the volatility in 1st lag

U t-1—actual variance

Sigma t2—predicted variance

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Error term is multiplied

 ARCH – a statistical model used to analyse volatility in time series in order to forecast future
volatility.
 The time series has a changing variance or volatility (heteroskedasticity) that depends on
(conditional on) lagged effects (autocorrelation)
 Popularized (1982) by Nobel Prize winner – Robert F. Engel ---replaced the concept of
constant volatility to conditional volatility

ARCH models are commonly employed in modelling financial time series that exhibit-

time-varying volatility and volatility clustering.

ARCH-type models are sometimes considered to be in the family of stochastic volatility models.

Autoregressive conditional heteroskedasticity (ARCH) models measure volatility and forecast it into
the future.

ARCH provided a model that economists could use instead of a constant or average for volatility.
Most ARCH model variants analyse past data to adjust the weightings using a maximum likelihood
approach. This results in a dynamic model that can forecast near-term and future volatility with
increasing accuracy.

The equation for a general ARCH(q) model will be -

𝜎𝑡2 = 𝛼0 + 𝛼1(𝑢𝑡−1)2 + 𝛼2(𝑢𝑡−2) 2 +. . . +𝛼𝑞(𝑢𝑡−q)2

Where, 𝜎𝑡2 is the estimated variance and α1,2,3..q are the ARCH coefficients impacting the lagged
2
values of the squared returns. Also, 𝑢𝑡 = 𝜎𝑡 * εt
2

Usesrisky ,residuals check in model- we don’t want model to have heteroskedastic and doesn’t

show any trend

ARCH(1)—residuals votality
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conditional heavy tails--bound to get some kind of changing variance

red and green—actual and predicted

blue -residuals—changing variance with time, there are elements of cyclicity or trend in the graph—

residuals should come out as white noise

clusters of volatility

apply Arch model

Et—residulals—error

Wt –error term multiplied

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Generalized Autoregressive Conditional Heteroskedasticity (GARCH) Model

Sigma2—long term variance we also taking into account the unconditional part of
variance in garch

ARCH AND GARCH difference

ARCH(1)-high volatity today tomorrow will also be high volality

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GARCH(1,1)-lag one return squared and lag 1 variance

Ar and arma difference above

GARCH, is an extension of the ARCH model that incorporates a moving average component together
with the autoregressive component. The introduction of a moving average component allows the
model to both model the conditional change in variance over time as well as changes in the time-
dependent variance.

A generally accepted notation for a GARCH model is to specify the GARCH() function with
the p and q parameters GARCH(p, q); for example GARCH(1, 1) would be a first order GARCH model.
As such, the model introduces a new parameter “p” that describes the number of lag variance terms.

The equation for simple GARCH(1, 1) model will be –

𝜎𝑡2 = ω + 𝛼1(𝑢𝑡−1)2 + β1(σ𝑡−1) 2

Where, 𝜎𝑡2 is today’s estimated variance, ω is the long-run average level of variance, 𝑢𝑡−1 is the
most recent (last lag) squared return and σ𝑡−1 is the volatility estimate of the last lag. Also, 𝛼1 &
β1 are the coefficients weighting on last lagged squared return and last lagged volatility estimate,
respectively.

Little about the E-GARCH Model - EXTRA (Not included in the curriculum)
These variant models often introduce changes in terms of weighting and conditionality in order to
achieve more accurate forecasting ranges. For example, EGARCH, or exponential GARCH, gives a
greater weighting to negative returns in a data series as these have been shown to create more
volatility. Put another way, volatility in a price chart increases more after a large drop than after a
large rise. Other different type of models, like HAR (Heterogeneous AutoRegressive model)
incorporate not only daily but weekly and monthly volatilities also in the volatility dynamics in an
attempt to supposedly achieve superior forecast performance compared with other volatility model.
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E -GARCH is the Exponential GARCH Model (Exponential - Generalized AutoRegressive Conditional

Heteroskedasticity Model). It also caters to the leverage effect as it takes into account the impact of
negative side of returns more clearly than the positive side of returns. It gives a greater weightage to
the negative returns than the positive returns in a data series, because as we know as per the
leverage effect there’s asymmetry in the returns in terms of volatility and the negative shocks or the
negative returns are found to be creating more volatility.

Like - In GARCH(1,1) model – the equation included one constant omega- carrying the element of
unconditional volatility– along with alpha coefficient which is affecting my last value of squared
returns – and Beta – which is affecting the variance or volatility in the last lag. But -There is one more
thing in GARCH – which is that all these three parameters – Omega, Alphas and Betas should be
positive- that is the pre-requisite for that model – these coefficients should not be negative.

Now – this Equation changes quite a bit in case of EGARCH to take the leverage effect into account –
but it makes these changes with a lot of flexibility. The equation looks like this-

2
log σ t =ω+ α 1
| |
yt −1

σ t −1
+θ1
yt
σ t−1
−1 2
+ β1 log σ t −1

Here – Omega (ω) is the constant carrying the long run unconditional variance, Alpha (α) and Beta
(β) are the same ARCH & GARCH coefficients respectively - which are affecting our last lags – and this
additional coefficient Theta (θ) – this represents the asymmetric term of the equation – when this
coefficient Theta (θ) is zero – the model becomes symmetric. But a non-zero coefficient Theta (θ)–
will be able to capture the asymmetry – that means the leverage effect. When this Theta (θ) is
negative- it estimates the negative shocks – it addresses the negative news - and passes the results
in higher volatility. So, after the estimation of these coefficients – if your Theta (θ) value comes out
negative – that means that time series you are looking into – has this behaviour present in it – that in
the past it has shown the leverage effect – it has reacted greatly to the negative news – because the
negative shocks have increased volatility more in this time series – as compared to the positive
jumps of the same magnitude.

Here, the whole equation is written using the natural log function – which in a way gives this
flexibility to these parameters - Omega, Alphas, Betas & Thetas of different lags - to go into any
domain of positive or negative numbers. And of course - other than giving this freedom to the
parameters- this equation also includes the asymmetry– that is the Leverage effect.