28-11-2020

Volatility
– Smiles and Estimation
Sankarshan Basu
Professor of Finance
Indian Institute of Management
Bangalore

Definition of Volatility
• Suppose that Si is the value of a variable on day i.
The volatility per day is the standard deviation of
ln(Si /Si-1)
• Normally days when markets are closed are
ignored in volatility calculations.
• The volatility per year is 252 times the daily
volatility
• Variance rate is the square of volatility

Nature of Volatility
• Volatility is usually much greater when the
market is open (i.e. the asset is trading) than
when it is closed.
• For this reason time is usually measured in
“trading days” not calendar days when
options are valued.

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Trading Days vs. Calendar Days

• Volatility per annum
= Volatility per trading day*√(Number of
trading days per annum)
• The number of trading days per annum is
usually assumed to be 252 for stocks.
• If T is the life of an option, then
T = (Number of trading days until option
maturity)/252
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Lognormal Property of Stock Price

• It follows from this assumption that
 2  
ln ST  ln S0     T,  T 
 2  
or
  2  
ln ST   ln S0     T,  T 
  2  

• Since the logarithm of ST is normal, ST is

lognormally distributed.
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Estimating Volatility from Historical Data

• Take observations S0, S1, . . . , Sn at intervals of t years for
n+1 no. of observations.
• Calculate the continuously compounded return in each
interval as:
 S 
ui  ln i 
 S i 1 
• Calculate the standard deviation, s , of the ui´s
s
• The historical volatility estimate is  ˆ 
t
• The standard error of this estimate is approximately
ˆ

2n

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The Black-Scholes Pricing Formulas

c  S 0 N (d1 )  K e  rT N (d 2 )
p  K e  rT N ( d 2 )  S 0 N (d1 )
ln(S 0 / K )  (r   2 / 2)T
where d1 
 T
ln(S 0 / K )  (r   2 / 2)T
d2   d1   T
 T

Implied Volatilities
• Of the variables needed to price an option the
one that cannot be observed directly is
volatility.
• We can therefore imply volatilities from
market prices and vice versa using the Black-
Scholes-Merton option pricing equation and
back calculating the implied volatility by
incorporating the values all other parameters
in the equation.

Normal and Heavy-Tailed Distribution

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Volatility Smile for Equity Options

Implied
Volatility The volatility
decreases as the
strike price
increases. Also
referred to as
volatility skew.

Strike
Price

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Implied Distribution for Equity Options

• The implied distribution is skewed compared to lognormal
distribution. The right tail is less heavy and the left tail is
heavier than the lognormal distribution.

• Consider a deep oom call option with a high strike price compared
to spot price. With less heavy tail, prob(S>K) is lower in
implied distribution than lognormal leading to lower price with
implied distribution. A relatively lower price leads to relatively
lower implied volatility.

• Consider a deep oom put option with a low strike price compared
to spot price. With a heavier tail, prob(S<K) is higher in
implied distribution than lognormal leading to higher price with
implied distribution. A relatively higher price leads to relatively
higher implied volatility.

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Reasons for Volatility Smiles

• Equity
- Crashophobia
- Leverage effect: As a company’s equity value declines,
leverage increases making equity more risky with increased
volatility and vice versa. So, volatility of equity price is a
decreasing function of strike price.

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Volatility Term Structure

• In addition to calculating a volatility smile,
traders also calculate a volatility term
structure.
• This shows the variation of implied volatility
with the time to maturity of the option.
• The volatility term structure tends to be
downward sloping when volatility is high and
upward sloping when it is low

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Volatility Surface
Volatility surface combines volatility smiles
with the volatility term structure to tabulate
the volatilities appropriate for pricing an
option with any strike price and any maturity.

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Example of a Volatility Surface

K/S0

0.90 0.95 1.00 1.05 1.10

1 mnth 14.2 13.0 12.0 13.1 14.5

3 mnth 14.0 13.0 12.0 13.1 14.2
6 mnth 14.1 13.3 12.5 13.4 14.3
1 year 14.7 14.0 13.5 14.0 14.8
2 year 15.0 14.4 14.0 14.5 15.1
5 year 14.8 14.6 14.4 14.7 15.0

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VIX Index: A Measure of the Implied Volatility of

the S&P 500
90
80
70
60
50
40
30
20
10
0

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Standard Approach to Estimating Volatility

• Define n as the volatility per day between day n-
1 and day n, as estimated at end of day n-1
• Define Si as the value of market variable at end of
day i
• Define ui= ln(Si/Si-1)

1 m
 n2   (u  u ) 2
m  1 i 1 n  i
1 m
u u
m i 1 n i

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Simplifications Usually Made in

Risk Management
• Define ui as (Si−Si-1)/Si-1
• Assume that the mean value of ui is zero
• Replace m-1 by m

This gives
1 m 2
 2n   u
m i 1 n  i

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Weighting Scheme
Instead of assigning equal weights to the
observations we can set

 2n  i 1  i un2i
m

where
m


i 1
i 1

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ARCH(m) Model
In an ARCH(m) model we also assign some
weight to the long-run variance rate, VL:

 2n  VL  i 1  i u n2i
m

where
m
   i  1
i 1

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EWMA Model
• In an exponentially weighted moving average
model, the weights assigned to the u2 decline
exponentially as we move back through time
• This leads to

 2n   2n 1  (1   )u n21

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Attractions of EWMA
• Relatively little data needs to be stored
• We need only remember the current estimate
of the variance rate and the most recent
observation on the market variable
• Tracks volatility changes
•  = 0.94 has been found to be a good choice
across a wide range of market variables

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GARCH (1,1)
In GARCH (1,1) we assign some weight to the
long-run average variance rate

 2n  VL  u n21  b2n 1

Since weights must sum to 1

    b 1

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GARCH (1,1) continued

Setting w  VL the GARCH (1,1) model is

 2n  w  u n21  b 2n 1
and

w
VL 
1   b

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Example
• Suppose

 n2  0.000002  013
. un21  0.86 n21
• The long-run variance rate is 0.0002 so that
the long-run volatility per day is 1.4%

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Example continued
• Suppose that the current estimate of the
volatility is 1.6% per day and the most recent
percentage change in the market variable is
1%.
• The new variance rate is
0.000002  013
.  0.0001  0.86  0.000256  0.00023336
The new volatility is 1.53% per day

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GARCH (p,q)

p q

 n2  w    i un2i   b j  n2 j
i 1 j 1

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The GARCH Estimate of Volatility of

the S&P 500
w0.0000013465, 0.083394, b0.910116

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