Quantitative Finance

Volatility Modeling using Daily Data

Jesús Ramirez

Universidad del Pacífico

Table of contents

1. Introduction

2. Simple Variance Forecasting

3. The GARCH Variance Model

1
Introduction
General Overview

• First, we will establish a framework for modeling the dynamic

distribution of portfolio returns.
• Second, we will use the model for forecasting dynamic portfolio
variance.
• Later, we will introduce methods for evaluating the performance
of these forecasts.
• Finally, we will consider ways to model non-normal features of
portfolio returns.

2
Overview

• We will discuss the simplest variance model, the RiskMetrics

model.
• We will introduce the GARCH variance model and compare it
with the RiskMetrics model.
• We will estimate the GARCH parameters using quasi-maximum
likelihood method.
• We will consider extensions to capture variance persistence and
leverage effects.
• We will talk about methods for evaluating the volatility
forecasting models.

3
Some facts about volatility

Although volatility is not directly observable, it has some common

characteristics:

• There exist volatility clusters, i.e. volatility is high in certain time

periods and low for other periods.
• Volatility evolves over time in a continuous fashion, i.e. volatility
jumps are rare.
• Volatility does not diverge to infinity, that is, volatility is often
stationary.
• Volatility seems to react differently to a large price increase or
to a large price drop,referred to as leverage effect.

4
Some facts about volatility

Figure 1: S&P 500 log returns

5
Simple Variance Forecasting
Assumptions

Main assumptions

• Let St be the daily closing price at t, then we will define the daily
asset log return as

Rt+1 = ln(St+1 /St )

• We will assume that

iid
Rt+1 = σt+1 zt+1 , with zt+1 ∼ N (0, 1)

• We need to establish a model for a time-varying variance to

know the entire distribution of the asset returns.

6
Simplest Model

• The variance, measured by the squared returns, shows strong

autocorrelation.
• A simplest way to capture this fact is by letting tomorrow’s
variance be the average of the recent observations.

1 ∑ 2 ∑ 1
m m
2
σt+1 = Rt+1−τ = R2t+1−τ
m τ =1 τ =1
m

• The forecast for tomorrow’s variance is immediately available at

the end of today when the daily return is realized.

7
Disadvantages

• An extreme return today will bump up variance by 1/m times the

squared return for m days after which variance will drop back
down.
• Autocorrelation of squared returns suggest a smoother decline
in the effects of past returns on today’s variance.
• It is unclear how we should choose m, which is a key parameter
in deciding the pattern of σt+1 .

8
RiskMetrics

• RiskMetrics1 model considers weights on past squared returns

that decay exponentially as we move backward in time.

RiskMetrics variance model

• The RiskMetrics variance model or exponential smoother is

written as
∞
∑
2
σt+1 = (1 − λ) λτ −1 R2t+1−τ , with 0 < λ < 1
τ =1

1 RiskMetrics is a system for market risk management developed by JP Morgan

9
RiskMetrics

RiskMetrics variance model

• It can show that the previous expression can be written as

2
σt+1 = λσt2 + (1 − λ)R2t

• The forecast for tomorrow’s volatility can be seen as a weighted

average of today’s volatility and today’s squared return.

10
Advantages

• Recent return matter more for tomorrow’s variance than distant

returns as λ < 1.
• The model only contains one parameter that need to be
estimated, namely λ.
• Relatively little data is needed in order to compute tomorrow’s
variance.

11
The GARCH Variance Model
Volatility Modeling

Simplest GARCH model

The simplest generalized autoregressive conditional heteroske-
dasticity (GARCH) model of dynamic variance can be written as
2
σt+1 = ω + αR2t + βσt2 , with 0 < α, β < 1 and α + β < 1

• What can we say about RiskMetrics and GARCH?

12
Long-run Volatility

Long-run volatility

• The unconditional or long-run average variance, σ 2 , is defined in

the previous GARCH as

σ 2 = ω/(1 − α − β)

• If we substitute the long-run variance into the dynamic variance

equation we have
2
σt+1 = σ 2 + α(R2t − σ 2 ) + β(σt2 − σ 2 )

13
Forecast

Forecasting volatility

• The one-day forecast of variance, Et σt+1

2 2
is given by σt+1 .
• We can prove that the k-days ahead forecast of variance is given
by
2
Et σt+k − σ 2 = (α + β)k−1 (σt+1
2
− σ2 )

• We will refer to α + β as the persistence of the model.

14
GARCH vs RiskMetrics

• High persistence implies that shocks that push variance away

from its long-run average will persist for a long time.
• When α + β is close to 1, GARCH and RiskMetrics might yield
similar predictions for short-horizons.
• However, in the RiskMetrics model a high variance day will
predict all the future days will be high variance.

15