7FNCE026W

Seminar 5: Volatility Modelling

1. The volatility of an asset is 2% per day. What is the standard deviation of the
percentage price change in three days?

2% × √3 = 3.46%.

2. The volatility of an asset is 25% per annum. What is the standard deviation of the
percentage price change in one trading day?

The standard deviation of the percentage price change in one day is 25∕ √252 = 1.57%.

3. Why do traders assume 252 rather than 365 days in a year when using volatilities?

Volatility is much higher when markets are open than when they are closed. Traders
therefore measure time in trading days rather than calendar days.

4. Suppose that observations on an exchange rate at the end of the past 11 days have
been 0.7000, 0.7010, 0.7070, 0.6999, 0.6970, 0.7003, 0.6951, 0.6953, 0.6934,
0.6923, and 0.6922. Estimate the daily volatility.

The standard formula for calculating standard deviation (from a sample) gives 0.45% per
day.

5. Explain the exponentially weighted moving average (EWMA) model for estimating
volatility from historical data.

The variance estimated at the end of day t − 1 for day t equals λ times the variance
calculated at the end of day t − 2 for day t − 1 plus (1 – λ) times the squared return on
day t - 1. This is equivalent to assigning weights to squared returns that decline
exponentially as we move back through time.

6. What is the difference between the exponentially weighted moving average model
and the GARCH(1,1) model for updating volatilities?

GARCH(1,1) adapts the EWMA model by giving some weight to a long-run average
variance rate. Whereas the EWMA has no mean reversion, GARCH(1,1) is consistent with
a mean-reverting variance rate model.
 7. A company uses an EWMA model for forecasting volatility. It decides to change the
parameter λ from 0.95 to 0.85. Explain the likely impact on the forecasts.

Reducing λ from 0.95 to 0.85 means that more weight is given to recent observations of
Ri and less weight is given to older observations. Volatilities calculated with λ = 0.85 will
react more quickly to new information and will bounce around much more than
volatilities calculated with λ = 0.95.

8. A company uses the GARCH(1,1) model for updating volatility. The three
parameters are ω, α, and β. Describe the impact of making a small increase in each
of the parameters while keeping the others fixed.

The weight given to the long-run average variance rate is 1 − α − β and the long-run
average variance rate is ω∕(1 − α − β). Increasing ω increases the long-run average
variance rate. Increasing α increases the weight given to the most recent data item,
reduces the weight given to the long-run average variance rate, and increases the level
of the long-run average variance rate. Increasing β increases the weight given to the
previous variance estimate, reduces the weight given to the long-run average variance
rate, and increases the level of the long-run average variance rate.

9. The most recent estimate of the daily volatility of an asset is 1.5% and the price of
the asset at the close of trading yesterday was $30.00. The parameter  in the
EWMA model is 0.94. Suppose that the price of the asset at the close of trading
today is $30.50. How will this cause the volatility to be updated by the EWMA
model?

EWMA model: σ 2t =λ σ 2t−1 +(1−λ)R 2t−1

❑ ❑
With σ t−1 = 0.015 and Rt −1 = (30.5-30)/30 = 0.01667
❑
 σ 2t =0.94 × 0.015❑2 + 0.06 ×0.016672❑ = 0.0002281  σ t = 1.5103%

10. Assume that an index at close of trading yesterday was 1,040 and the daily
volatility of the index was estimated as 1% per day at that time. The parameters in
a GARCH(1,1) model are ω = 0.000002, α = 0.06, and β = 0.92. If the level of the
index at close of trading today is 1,060, what is the new volatility estimate?

Rt −1 = 20∕1,040 = 0.01923 so that σ 2t = 0.000002 + 0.06 × 0.019232 + 0.92 × 0.012 =

❑
0.0001162. This gives σ t = 0.01078. The new volatility estimate is therefore 1.078% per day.
 11. The most recent estimate of the daily volatility of the dollar–sterling exchange rate
is 0.6% and the exchange rate at 4:00 p.m. yesterday was 1.5000. The parameter λ
in the EWMA model is 0.9. Suppose that the exchange rate at 4:00 p.m. today
proves to be 1.4950. How would the estimate of the daily volatility be updated?

The proportional daily change is −0.005∕1.5 = −0.003333. The current daily variance
estimate is 0.0062 = 0.000036. The new daily variance estimate is 0.9 × 0.000036 + 0.1 ×
0.0033332 = 0.000033511. The new volatility is the square root of this. It is 0.00579 or
0.579%.

12. Suppose that the price of gold at close of trading yesterday was $300 and its
volatility was estimated as 1.3% per day. The price of gold at the close of trading
today is $298. Suppose further that the price of silver at the close of trading
yesterday was $8, its volatility was estimated at 1.5% per day, and its correlation
with gold was estimated as 0.8. The price of silver at the close of trading today is
unchanged at $8.
a. Update the volatility of gold and silver and the correlation between gold
and silver using:
i. The EWMA model with λ=0.94
ii. The GARCH(1,1) model with ω=0.000002, α=0.04, β=0.94
b. In practice, is the ω parameter likely to be the same for gold and silver?

a.
❑ ❑
For gold, we have: σ t−1 = 0.013 and Rt −1 = (298-300)/300 = -0.00667
2 2 2 ❑
 EWMA: σ t =0.94 × 0.013❑ + 0.06 ×0.00667❑ = 0.00016153  σ t = 1.271%
❑
 GARCH: σ 2t =0.000002+0.04 × 0.00667❑2 + 0.94 ×0.013❑2 = 0.00016264  σ t = 1.275%
❑ ❑
For silver, we have: σ t−1 = 0.015 and Rt −1 = 0
❑
 EWMA: σ 2t =0.94 × 0.015❑2 = 0.0002115  σ t = 1.454%
❑
 GARCH: σ 2t =0.000002+0.94 × 0.015❑2 = 0.0002135  σ t = 1.461%

For the correlation between gold and silver, we need to first calculate the most recent
❑
covariance: σ (g , s ), t−1=¿ 0.8 × 0.013 × 0.015 = 0.000156

Then update this covariance with each model:

❑
 EWMA: σ (g , s), t=¿ 0.94 × 0.000156 = 0.00014664
 ρ gs ,t =¿ 0.00014664/(0.01454*0.01271) = 0.7934
❑
 GARCH: σ (g , s), t=¿ 0.000002 + 0.94 × 0.000156 = 0.00014864
 ρ gs ,t =¿ 0.00014864/(0.01461*0.01275) = 0.7977

b.
For a given α and β, the ω parameter defines the long run average value of a variance or a
covariance. There is no reason why we should expect the long run average daily variance for
gold and silver to be the same. There is also no reason why we should expect the long run
average covariance between gold and silver to be the same as the long run average variance
of gold or the long run average variance of silver. In practice, therefore, we are likely to
want to allow ω in a GARCH(1,1) model to vary from market variable to market variable.