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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.

Then we can get a simple formula for the variance rate


m
1
n2 u n2i
m i 1

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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

Adding a long-run average variance rate and be given a weight


m

VL i u
2
n

i 1

( i 1)

2
ni

i 1

Where VL is the long-run variance rate and

Defining

is the weight assigned to VL

VL , then the model can be written:


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

u 2 and the most recent estimate of the variance rate.

Setting VL , the GARCH(1, 1) model can also be written:

n2 un21 n21

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FRMFinancial Risk Manager

Estimating Volatilities
GARCH(1, 1) Model

n2 VL un21 n21

Persistence: 1-= (+),

It defines the speed at which


shocks to the variance revert to

their long-run values.

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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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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Estimating Correlations
Estimating Correlations

XY

cov n

x ,n y ,n

For EWMA model

covn covn1 (1 ) xn1 yn1

For GARCH(1,1) model

covn xn1 yn1 covn1

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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

(2.8%) 2 (2.86%) 2 (1 )(0.50%) 2


0.9572 0.96

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201405

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201405
Answer: B

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FRM

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