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August 14 2009| Filed Under » Active Trading, Formulas, Stocks, Volatility Many investors have experienced abnormal levels of investment performance volatility during various periods of the market cycle. While volatility may be greater than anticipated during certain periods of time, a case can also be made that the manner in which volatility is typically measured contributes to the problem of unexpected volatility. The purpose of this article is to discuss the issues associated with the traditional measure of volatility, and to explain a more intuitive approach that can be used by investors in order to help them evaluate the magnitude of their investment risks. Traditional Measure of Volatility Most investors should be aware that standard deviation is the typical statistic used to measure volatility. Standard deviation is simply defined as the square root of the average squared deviation of the data from its mean. While this statistic is relatively easy to calculate, the assumptions behind its interpretation are more complex, which in turn raises concern about its accuracy. As a result, there is a certain level of skepticism surrounding its validity as an accurate measure of risk. (To learn more, see The Uses And Limits Of Volatility.)

To explain, in order for standard deviation to be an accurate measure of risk, an assumption has to be made that investment performance data follows a normal distribution. In graphical terms, a normal distribution of data will plot on a chart in a manner that looks like a bell shaped curve. If this standard holds true, then approximately 68% of the expected

investment performance is typically skewed. risk can be captured and analyzed in a . a problem known as heteroskedasticity is also a cause for concern. see our CFA Level 1. which means that return distributions are typically asymmetrical.5%.Quantitative Methods Exam Guide. the ramifications of heteroskedasticity will cause standard deviation to be an unreliable measure of risk. and distort the accuracy of standard deviation as a measure of risk. Second. Heteroskedasticity simply means that the variance of the sample investment performance data is not constant over time.) Learn to trade Forex with FXCM’s Free Trading Guide A Simplified Measure of Volatility Fortunately. 1979 through June 1.5% ±10%). and 99% should lie between ±3 standard deviations. Taken together. and its standard deviation was 10%. during the period of June 1. these problems warp the look of the bell shaped curve. Like skewness and kurtosis. these three problems can cause investors to misunderstand the potential volatility of their investments. one would expect that 68% of the time the expected performance of the S&P 500 index would fall within a range of -0. First. there are three main reasons why investment performance data may not be normally distributed. As a result. and cause them to potentially take much more risk than anticipated.5% and 19. investors tend to experience abnormally high and low periods of performance. the three-year rolling annualized average performance of the S&P 500 Index was 9.outcomes should lie between ±1 standard deviations from the investment’s expected return. Through a process known as the historical method. For example. Given these baseline parameters of performance. standard deviation tends to fluctuate based on the length of the time period used to make the calculation. 2009. there is a much easier and more accurate way to measure and examine risk. 95% should lie between ±2 standard deviations. which means that investment performance exhibits an abnormally large number of positive and/or negative periods of performance. (To learn more. Unfortunately. investment performance typically exhibits a property known as kurtosis.5% (9. or the period of time selected to make the calculation. Taken collectively. As a result. In addition to skewness and kurtosis.

in the chart below. 7. To utilize this method.1%.8%. Figure 1: S&P 500 Index Performance Histogram Source: Investopedia 2009 As the chart illustrates. or below a given range. the use of a histogram allows investors to determine the percent of time in which the performance of an investment is within. 16% of the time. A histogram is a chart that plots the proportion of observations that fall within a host of category ranges. and performance above 24.7% of the time. For example. by generating a chart known as a histogram. the three-year rolling annualized average performance of the S&P 500 Index for the period of June 1. . The vertical axis represents the magnitude of the performance of the S&P 500 Index. and the horizontal axis represents the frequency in which the S&P 500 Index experienced such performance. investors simply need to graph the historical performance of their investments. 16% of the S&P 500 Index performance observations achieved a return between 9% and 11. 1979 through June 1. In terms of performance below or above a threshold. it can also be determined that the S&P 500 Index experienced a loss greater than or equal to 1.7%. For example. above. 2009 has been constructed.more informative manner than through the use of standard deviation.

even with this one caveat. Third. investors can examine the magnitude of gains and losses experienced. investors should be able to easily generate a histogram. like the use of standard deviation. In any event. However. and then manually calculating investment performance. such as Microsoft Excel. By utilizing this methodology. the historical method does not require that investment performance be normally distributed. and should be used by investors for evaluating the magnitude and frequency of their potential gains and losses associated with their investment opportunities. which provides investors with the necessary information to mitigate unexpected volatility surprise. However. which in turn should help them gauge the true volatility of their investment opportunities. the question then becomes: How do investors generate a histogram in order to help them examine the risk attributes of their investments? One recommendation is to request the investment performance information from the investment management firms. suffers from the potential impact of heteroskedasticity. typically found through various sources. the impact of skewness and kurtosis is explicitly captured in the histogram chart. as investors should understand that past performance is not indicative of future returns. this should not be a surprise. the historical method still serves as an excellent baseline measure of investment risk. The only drawback to the historical method is that the histogram. First. the utilization of a histogram should allow investors to examine the risk .Comparing the Methods The use of the historical method via a histogram has three main advantages over the use of standard deviation. Application of the Methodology Now that investors understand that the historical method can be used as an informative way to measure and analyze risk. the necessary information can also be obtained by gathering the monthly closing price of the investment option. Second. and using the software’s data analysis add-on feature. After performance information has been gathered. Conclusion In practical terms. or manually calculated. a histogram can be constructed by importing the data into a software package.

because some fluctuations are expected to cancel each other out. rather than increase linearly. An implied volatility is derived from the market price of a market traded derivative (in particular an option).of their investments in a manner that will help them gauge the amount of money they stand to make or lose on an annual basis. the volatility increases with the square-root of time as time increases. This phrase is used particularly when it is wished to distinguish between the actual current volatility of an instrument and actual historical volatility which refers to the volatility of a financial instrument over a specified period but with the last observation on a date in the past actual future volatility which refers to the volatility of a financial instrument over a specified period starting at the current time and ending at a future date (normally the expiry date of an option) historical implied volatility which refers to the implied volatility observed from historical prices of the financial instrument (normally options) current implied volatility which refers to the implied volatility observed from current prices of the financial instrument future implied volatility which refers to the implied volatility observed from future prices of the financial instrument For a financial instrument whose price follows a Gaussian random walk. Volatility terminology Volatility as described here refers to the actual current volatility of a financial instrument for a specified period (for example 30 days or 90 days). It is the volatility of a financial instrument based on historical prices over the specified period with the last observation the most recent price. and therefore they should feel much more content with their investment exposure during all economic environments. . others such as the Lévy distribution are often used. see Understanding Volatility Measurements. the width of the distribution increases as time increases. volatility is a measure for variation of price of a financial instrument over time. or Wiener process. This is because there is an increasing probability that the instrument's price will be farther away from the initial price as time increases. investors should be less surprised when the markets fluctuate dramatically. so the most likely deviation after twice the time will not be twice the distance from zero. Since observed price changes do not follow Gaussian distributions. (For more.[1] These can capture attributes such as "fat tails". Historic volatility is derived from time series of past market prices. However. Given this type of real-world applicability.) In finance.

with the same expected return of 7% but with annual volatility of 20%.[4] In today's markets. 1) The wider the swings in an investment's price the harder emotionally it is to not worry.[2] Glosten and Milgrom (1985) shows that at least one source of volatility can be explained by the liquidity provision process. Two instruments with different volatilities may have the same expected return. 2) When certain cash flows from selling a security are needed at a specific future date. with annual volatility of 5%. This is because when calculating standard deviation (or variance). A higher volatility stock. and amongst the models are Bruno Dupire's Local Volatility. and the increasingly popular Heston model of Stochastic Volatility. Poisson Process where volatility jumps to new levels with a predictable frequency. These estimates assume a normal distribution. For example. Roll (1984) shows that volatility is affected by market microstructure. and yet few theoretical models explain how volatility comes to exist in the first place. but the instrument with higher volatility will have larger swings in values over a given period of time. merely their dispersion. all differences are squared. through the use of derivative securities such as options and variance swaps. See Volatility arbitrage. [edit] Volatility versus direction Volatility does not measure the direction of price changes. would indicate returns from approximately negative 33% to positive 47% most of the time (19 times out of 20. this is not observed in real markets.[edit] Volatility and Liquidity Much research has been devoted to modeling and forecasting the volatility of financial returns. in reality stocks are found to be leptokurtotic. This would indicate returns from approximately negative 3% to positive 17% most of the time (19 times out of 20. or 95% via a two standard deviation rule). which in turn increases the band of price oscillation.[5] . [edit] Volatility over time Although the Black Scholes equation assumes predictable constant volatility. 3) Higher volatility of returns while saving for retirement results in a wider distribution of possible final portfolio values. When market makers infer the possibility of adverse selection. so that negative and positive differences are combined into one quantity. higher volatility means a greater chance of a shortfall. 5) Price volatility presents opportunities to buy assets cheaply and sell when overpriced. it is also possible to trade volatility directly. a lower volatility stock may have an expected (average) return of 7%. 4) Higher volatility of return when retired gives withdrawals a larger permanent impact on the portfolio's value. or 95%).[3] [edit] Volatility for investors Investors care about volatility for five reasons. they adjust their trading ranges.

if the daily logarithmic returns of a stock have a standard deviation of σSD and the time period of returns is P. or going down by an unusual amount. Also.It is common knowledge that types of assets experience periods of high and low volatility. or going up by an unusual amount. And an increase in volatility does not always presage a further increase—the volatility may simply go back down again. while during other times they barely move at all. 'doldrums'. Of course. can last for a long time as well. a time when prices rise quickly (a possible bubble) may often be followed by prices going up even more.[6] The generalized volatility σT for time horizon T in years is expressed as: Therefore.[clarification needed] Most typically. or the opposite. This is termed autoregressive conditional heteroskedasticity. whether such large movements have the same direction. extreme movements do not appear 'out of nowhere'. during some periods prices go up and down quickly. [edit] Mathematical definition The annualized volatility σ is the standard deviation of the instrument's yearly logarithmic returns. they are presaged by larger movements than usual. is more difficult to say. That is. the annualized volatility is . Periods when prices fall quickly (a crash) are often followed by prices going down even more. The converse behavior.

e. if σSD = 0.. Then. T = 1/12 of a year) would be .01 the annualized volatility is The monthly volatility (i.A common assumption is that P = 1/252 (there are 252 trading days in any given year).

However. more generally. who looked at cotton prices and found that they followed a Lévy alpha-stable distribution with α = 1. but some people believe α < 2 for financial activities such as stocks. Suppose you notice that a market price index. This was discovered by Benoît Mandelbrot. indexes and so on.7. 19 April 1997.) [edit] Crude volatility estimation Using a simplification of the formulae above it is possible to estimate annualized volatility based solely on approximate observations. which has a . These formulas are accurate extrapolations of a random walk. for natural stochastic processes. whose steps have finite variance. or Wiener process. (See New Scientist. the precise relationship between volatility measures for different time periods is more complicated. Some use the Lévy stability exponent α to extrapolate natural processes: If α = 2 you get the Wiener process scaling relation.The formula used above to convert returns or volatility measures from one time period to another assume a particular underlying model or process.

798σ.current value near 10. has moved about 100 points a day. To annualize this. [edit] Estimate of compound annual growth rate (CAGR) Consider the Taylor series: Taking only the first two terms one has: . The net effect is that this crude approach underestimates the true volatility by about 20%. The rationale for this is that 16 is the square root of 256. for many days.000. the average magnitude of the observations is merely an approximation of the standard deviation of the market index. Assuming that the market index daily changes are normally distributed with mean zero and standard deviation σ. This also uses the fact that the standard deviation of the sum of n independent variables (with equal standard deviations) is √n times the standard deviation of the individual variables. you can use the "rule of 16". multiply by 16 to get 16% as the annual volatility. Of course. up or down. This would constitute a 1% daily movement. the expected value of the magnitude of the observations is √(2/π)σ = 0. on average. that is. which is approximately the number of trading days in a year (252).

Realistically. . Some people use the formula: for a rough estimate. where k is an empirical factor (typically five to ten). so this formula tends to be over-optimistic. most financial assets have negative skewness and leptokurtosis.

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