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# Estimating Volatilities and Correlations

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## FRMFinancial Risk Manager

Estimating Volatility
Define n as the volatility of a market variable on day n, as estimated at the end
of day n-1. n2 as the variance rate.
Define Si as the value of the market variable at the end of day i.
Define ui as the continuously compounded return during day i (between the end
of day i-1 and the end of day i)

Si
ui ln
Si 1

1 m
u un i
m i 1

m
1
2
n2
(
u

u
)

n i
m 1 i 1

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## FRMFinancial Risk Manager

Estimating Volatility
For the purpose of monitoring daily volatility, we give the following
changes:

is assumed to be zero.

m-1 is replaced by m.

m
1
n2 u n2i
m i 1

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## FRMFinancial Risk Manager

Estimating Volatility

Weighting Schemes

The above formula gives equal weight to un1 , un2 ,......, unm . Our objective
is to estimate the current level of volatility, so we give more weight to recent
data.
m

iu
2
n

i 1

i 1

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(i j where i j )

ni

## FRMFinancial Risk Manager

Estimating Volatilities
ARCH Model

m

VL i u
2
n

i 1

( i 1)

2
ni

i 1

Defining

m

iu 2
2
n

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i 1

ni

## FRMFinancial Risk Manager

Estimating Volatilities
EWMA Model

## In an exponentially weighted moving average model, the weights assigned to

the ai decline exponentially as we move back through time.
2
2n 2n-1 (1 )u n-1

The estimate, n , of the volatility for day n (made at the end of day n-1) is

calculated from n 1 ( the estimate that was made at the end of day n-2 of the
volatility for day n-1) and u n 1 (the most recent daily percentage change).

High values of will minimize the effect of daily percentage returns, whereas

low values of will tend to increase the effect of daily percentage returns on
the current volatility estimate.

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## FRMFinancial Risk Manager

Estimating Volatilities
GARCH(1, 1) Model

## In GARCH(1, 1), n2 is calculated from a long-run average variance rate, VL , as well

as from n1 and un 1 . The equation for GARCH(1, 1) is:

n2 VL un21 n21

## EWMA model is a particular case of GARCH(1, 1), where =0, =1- , = .

The (1,1) in GARCH(1, 1) indicates that n2 is based on the most recent observation
of

n2 un21 n21

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## FRMFinancial Risk Manager

Estimating Volatilities
GARCH(1, 1) Model

n2 VL un21 n21

## It defines the speed at which

shocks to the variance revert to

## The higher the persistence (given that

it is less than one), the longer it will
take to revert to the mean following a
shock or large movement.

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## FRMFinancial Risk Manager

Estimating Volatilities
Mean Reversion
Expected path for the variance rate
Variance rate

Variance rate

VL

VL

Time

Graph a

Time

Graph b

## (a) current variance rate is above long-term variance rate

(b) current variance rate is below long-term variance rate

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## FRMFinancial Risk Manager

Estimating Correlations
Estimating Correlations

XY

cov n

x ,n y ,n

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## FRMFinancial Risk Manager

201311

cov n cov n 1 (1 ) xn 1 yn 1
=0.9 0.000225+(1-0.9) 0.25% 1.5%
Answer: C

=2.025%%+0.0375%%=2.06265%%

XY
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cov n

x ,n y ,n

2.06265%%
0.66
1.25% 2.5%

## FRMFinancial Risk Manager

201405

Answer: A

1
1
23 0.9703
2
2
Weight for five days old= 4 (1 ) 0.97034 (1 0.9703) 0.026

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201405

n2 n21 (1 )un21
Answer: C

0.9572 0.96

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201405
Answer: B

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FRM

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