Risk Management Volatility

Volatility Modeling
Copyright © 2000 – 2006

Investment Analytics
1
Asset Return Characteristics
The Standard Gaussian Model
Thick Tails
Non-Normal Distribution
Volatility Clustering
Leverage
Volatility & Correlation
Copyright 2001-2006 Investment Analytics Volatility Slide: 2

Standard Gaussian Model
Asset returns follow random walk
Return this period independent of past
return
Asset returns are normally distributed
These assumptions underlie all major
financial theories
CAPM
Black-Scholes model

Thick Tails,
Non-Normal Distribution
Mandelbrot (1963), Fama (1963, 1965)
Skewness = -0.6
Kurtosis = 5.7

Tests for Normality
Error Distribution Moments
Skewness: should be ~ 0
Kurtosis: should be ~ 3
Statistical Tests
Lilliefors Kolmagorov-Smirnov nonparametric test
Shapiro-Wilk test
More powerful
Jarque-Bera Test
n[Skewness / 6 + (Kurtosis – 3)2 / 24] ~ χ2(2)

Volatility is Stochastic
Volatility - DOW Stocks
140%
120% DJIA IBM INTC IP JNJ
100%
80%
60%
40%
20%
0%
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Volatility Clustering
High vol. followed by high vol.
Decay back to normal levels
SP500 Index Volatility
160%
140%
120%
100%
80%
60%
40%
20%
0%
Jan-50
Jan-52
Jan-54
Jan-56
Jan-58
Jan-60
Jan-62
Jan-64
Jan-66
Jan-68
Jan-70
Jan-72
Jan-74
Jan-76
Jan-78
Jan-80
Jan-82
Jan-84
Jan-86
Jan-88
Jan-90
Jan-92
Jan-94
Jan-96
Jan-98
Jan-00
The Volatility Cone
Volatility(%)
Maximum
Average
Minimum
0 30 60
Days
Leverage Effect
Black (1976)
Stock price changes negatively correlated with
volatility
Fixed costs provide a partial explanation
Firm with equity and debt becomes more leveraged
as stock falls
Raises equity returns risk/volatility
Correlation too large to be explained by
leverage alone
Christe (1982), Schwert (1989)
Volatility Seasonality
DOW Volatility Seasonality
160%
140%
120%
100%
80%
60%
40%
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC

Volatility Correlation
Volatilities tend to change together
Stocks: Black (1976)
FX: Diebold & Nerlove (1989)
Also across markets
Stock & bond volatilities move together
(Schwert, 1989)

Volatility Correlation
Correlation: IBM vs JNJ Volatility
1.2
1.0
0.8
0.6
0.4
0.2
0.0
May-85 May-88 May-91 May-94 May-97 May-00
-0.2
-0.4

Asset Characteristics –
Conclusions
The Bad News
iid Gaussian model inappropriate
The Good News
Correlation suggests few common factors
may explain variation
Volatility models (GARCH, etc.)

Volatility Metrics
Consider statistic f of log asset price siH,(i+1)H
If f is homogeneous in some power γ of
volatility,then
γ
f ( siH ,(i +1) H ) = σ iH f ( s iH ,( i+1) H )
*
and
ln f (s iH ,( i +1) H ) = γ ln σ iH + ln f (s iH
*
, ( i +1) H )
Where s* is standardized diffusion with unit volatility

Standard Volatility Metrics
Squared or absolute returns
ln f ( siH ,(i +1) H ) = γ ln σ iH + γ ln s(*i +1) H − siH
*
γ only scales proxy, does not affect distribution

Very noisy
Non-Gaussian
Skew –1.09, kurtosis 5.0
Problems with bias in Gaussian QMLE
Andersen & Sorensen (1997)

Log Absolute Returns
Log Absolute Returns SP500 Index Jan 1983- Jul 2002
X <= -7.4417 X <= -3.5022
5.0% 95.0%
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
-12 -10 -8 -6 -4 -2 0

Realized Volatility
Anderson, Bollerslev, Diebold (2000)
Dow 30 stock volatility
Uses high frequency data
Idea: diffusion coefficients can be
estimated arbitrarily well
Given fine enough sampling
Merton (1980), Nelson (1992)

Realized Volatility
Multivariate process
dpt = µ t dt + Ω t dWt
Ω is NxN positive definite diffusion matrix
Distribution of continuously
compounded returns is:
r σ [µ τ , Ω τ ]τ ~ N ⎛⎜ ∫ µ τ dτ , ∫ Ω τ dτ ⎞⎟
h h h
t + h ,t t+ t+ t+ t+
⎝ =0
⎠ 0 0
Convergence:
∑r
h
t + j∆ , ∆ • rt′+ j∆ ,∆ − ∫ Ω t +τ dτ → 0
0
j

Modeling with Realized
Volatility
Distribution properties
Realized volatility lognormally distributed
Returns standardized by realized volatility
are approximately Gaussian
Andersen & Bollerslev (1998)
Foreign exchange rate volatility
R2 increases with sampling frequency
Daily ~ 7%, 5 min ~ 48%

Example: DD Volatility
Histogram: LogStDev
K-S d=.03328, p> .20; Lilliefors p> .20
Shapiro-Wilk W=.99517, p=.13844
120
100
80
No. of obs.
60
40
20
0
-3 -2.8 -2.6 -2.4 -2.2 -2 -1.8 -1.6 -1.4 -1.2 -1 -0.8 -0.6 -0.4 -0.2 0
X <= Category Boundary

Realized Volatility: Conclusion
Significant gains to forecast accuracy
with high frequency estimation
Daily returns well described by
continuous normal-lognormal mixture
See Mixture of Distributions Hypothesis
(Clark 1973)

The Log Range
Difference in log of highest and lowest
log prices
⎡ ⎤
ln f ( siH ,(i +1) H ) = ln ⎢ sup st − inf st ⎥
⎣iH <t <(1+1) H iH <t < (1+1) H
⎦
⎡ ⎤
= ln σ iH + ln ⎢ sup s *t − inf s *t ⎥
⎣iH <t <(1+1) H iH <t < (1+1) H
⎦

Range in Volatility Estimation
Intuition
Days with large intraday moves
Close happens to be close to open
Range reflect true, higher intraday volatility
Historical Applications
Parkinson (1980)
Garman & Klass (1980)
Rogers & Satchell (1991)

Other Range-Based Metrics
Parkinson (5x efficiency)
1
σ=
2 N Ln(2)
∑ Ln( H i / Li )
Garman & Klass (7 x efficiency)

1 1
A B S [ ∑ [ L n ( H i / L i )] 2 −
N 2
σ =
1
N
∑ ( 2 L n ( 2 ) − 1 )[ L n ( C i / C i − 1 )] 2 ]

Properties of Log Range
Distribution
Very close to Normal
Dt ~N[0.43 + lnht, 0.292]
Where ht = σ / 2521/2
Typical skewness 0.28, kurtosis 3.2
Efficiency
Stdev approx ¼ of log abs return
Robustness
Not affected by bid/ask bounce to same degree as
realized volatility

Log Range for SP500 Index
Log Range SP500 Index Jan 1983- Jul 2002
X <= -5.5026 X <= -3.6733
5.0% 95.0%
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
-7 -6 -5 -4 -3 -2 -1

Example: GE Log Range
Histogram: GE
K-S d=.05215, p> .20; Lilliefors p> .20
Shapiro-Wilk W=.99131, p=.81256
50
45
40
35
30
No. of obs.
25
20
15
10
0
-3.5 -3 -2.5 -2 -1.5 -1
X <= Category Boundary

Robustness of Log Range vs
Realized Volatility
Alizadeh, Brandt, Diebold (2001)
Simulated performance of log range vs
realized volatility with bid/ask spreads
Actual daily vol was set at 1.87%
Volatility Estimates
Interval Realized Range
5-min 9.35 2.11
40-min 3.72 1.87
12 hour 1.79 0.68

Volatility Models
Key volatility characteristics
Long memory
Volatility of volatility
Univariate models
Multivariate models

Time Series Models
Autoregressive AR(1):
yt = a0 + a1yt-1 + εt
εt = sequence of independent random variables
Independent
Zero mean
Constant variance σ2
Differenced series (yt – (a0 + a1yt-1)) = εt
White noise

White Noise
Mean is constant (zero)
E(εt) = µ (0)
Variance is constant
Var(εt) = E(εt2) = σ2
Uncorrelated
Cov(εt , εt-j) = 0 for j < > 0 and t
Gaussian White Noise
If εt is also normally distributed
Strict White Noise
εt are independent
Stationarity
Weak (covariance) stationarity
Population moments are time-independent:
E(yt) = µ
Var(yt) = σ2
Cov(yt, yt-j) = γj
Example: white noise εt
Strong stationarity
In addition, yt is normally distributed

Stationary Series

Stationarity of AR(1) Process
AR(1) Process: yt = a0 + a1yt-1 + εt
Expected value E(yt) is time-dependent:
t −1
E ( yt ) = a0 ∑ a + a y 0 i
1
t
1
i =0
If |a1| < 1, then as t →∞, process is stationary
Lim E(yt) = a0 / (1 - a1)
Hence mean of yt is finite and time independent
Also Var(yt) = σ2/[1 - (a1)2]
And Cov(yt, ys) = σ2 (a1)s /[1 - (a1)2]

Random Walk Process
Random Walk with drift
yt = a0 + a1yt -1 + εt
With a1 = 1
A non-stationary process

Random Walk Process
Random Walk without drift

yt = a0 + a1yt -1 + εt
With a1 = 1, a0 = 0
A non-stationary process
Variance of yt gets larger over time
Hence not independent of time.
⎡n 2 ⎤
Var ( yt ) = E ⎢∑ ε t + 2∑ ε t ε s ⎥ = nσ 2
⎣1 t≠s ⎦
Random Walk Integration
First difference of RW is stationary
yt - yt -1 = εt
Changes in random walk are random white
noise
Integrated process, order 1

Denoted I(1)

Near-Random Walk Process
AR process with coefficient < 1
Very difficult to distinguish from random
walk
But difference is huge
AR(1) stationary, RW is not
Dickey-Fuller test
Best available, but not powerful

Long Memory
Idea: shocks persist over long time period
Long Memory autocorrelation function
Hyperbolic decay
1
ρ (t ) ~ L(t )t 2 d −1
as t → ∞, 0 < d <
2
Short Memory autocorrelation function
| ρ (t ) |≤ Cr |t |
for some C > 0, 0 < r <1
ARMA models only have short memory

Volatility Long Memory
Volatility is highly persistent
Events have sustained influence on
future volatility
In principle, process is very forecastable

Volatility Autocorrelations
Volatility Autocorrelations
0.5
0.4
DJIA
0.3
BA
DD
0.2
GE
0.1 HWP
IBM
0.0
1 4 7 10 13 16 19 22
-0.1
Months

Evidence for Volatility
Long Memory
Bollerslev & Mikkelsen (1996)
High persistence & fractional integration in SP500
index volatility
Baillie, Bollerslev, Mikkelsen (1996)
FX processes well modeled by FIGARCH
Grau-Carles (2000)
Long memory effects confirmed in volatility
processes for all major stock markets
Brunetti & Gilbert (2000)
Volatility in crude oil markets has long memory
and is fractionally cointegrated
Theories of
Long Memory in Volatility
Results from aggregation of a news arrival
process with different persistence levels
Zin & Bachus (1993)
Spread from other variables, e.g. inflation,
which themselves have long memory
Lamoureux & Lastrapes (1990)
Caused by regime switching

Rescaled Range Analysis
Developed by H.E. Hurst 1950’s
Brownian Motion
Distance traveled R ∝ T0.5
Hurst Exponent
(R/S)T = cTH
H is the Hurst Exponent
c is a constant
T is # observations
(R/S)T is the rescaled range, a standardized measure of
distance traveled
Note for random time series H = 0.5

Hurst Exponent &
Market Behavior
H measures persistence
Correlation C = 2(2H-1) - 1
White Noise: H = 0.5, C = 0
Black Noise: 0.5 < H < 1 , 0 < C < 1
Persistent, trend reinforcing series
“Long memory”
Pink Noise: 0 < H < 0.5, C < 0
Antipersistent, mean-reverting
Choppier, more volatile than random series

White Noise Process
Fractal Random Walk
20
-20
-40
-60
-80
H = 0.5
-100
-120
-140

Black Noise Process
Fractal Random Walk
100
-100
-200
-300
H = 0.9
-400
Smoother series
-500
Trend
-600

Pink Noise Process
Fractal Random Walk
15
10
-5
-10
-15

-20 H = 0.1
-25 More volatile
-30
Antipersistent
-35
Mean reverting

Simulating A Fractal
Random Walk
Feder (1988):
⎛ n−H ⎞ ⎧ nt (H−0.5)
[ ] ⎫
n(M−1)
∆yH (t) = ⎜⎜ ⎟⎟×⎨∑i E(1+n(M+1)−i) + ∑ (n+i)(H−0.5)
−i(H−0.5)
E(1+n(M−1+t)−i) ⎬
⎝ Γ(H +0.5) ⎠ ⎩i=1 i=1 ⎭
Ei is a strict white noise process, No(0, 1)

M is the number of periods for which long memory
is generated
n is set to 5
t is set to 1
H is Hurst exponent

Calculating (R/S)
Form series of returns
rt = Ln(Pt / Pt -1) for t = 1, 2, . . . , T
Divide into A contiguous sub-periods
Length n, such that An = T n
Compute average for each sub-period ra = ∑ rak

k =1
Form cumulative series
k
X ka = ∑ (ria − ra )
i =1
Define range Ra = Max(Xk,a) - Min(Xk,a)

Calculating (R/S)
Compute standard deviation
2 1/ 2
⎡1 n ⎤
S a = ⎢ ∑ (rka − ra ) ⎥
⎢⎣ n k =1 ⎥⎦
Calculate average R/S for each n
1 A
( R / S ) n = ∑ ( Ra / S a )
A a =1
Use OLS Regression to Estimate H

Ln(R/S)n = Ln(c) + H Ln(n)
Volatility R/S Analysis
GE - Rescaled Range Analysis
3.5
3.0 y = 0.843x - 0.825

R2 = 99%
2.5
Ln(R/S)
2.0
1.5
1.0
0.5
0.0
1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0
Ln(Months)

DOW Stock Volatility –
Hurst Exponents
Hurst Exponents - DOW Stocks
1.00
0.95
0.90
0.85
0.80
0.75
IBM
HON
MMM
DIS
MO
XOM
KO
JNJ
HD
GM
DD
IP
HWP
MCD
MRK
EK
SBC
JPM
GE
DJIA
INTC
MSFT
WMT
PG
BA
T
UTX
AXP
AA
CAT

Other Methods for Estimating
Fractional Integration
Lo (1991)
Modified R/S statistic
Peng et al (1994)
Detrended fluctuation analysis
Geweke & Porter-Hudak (1983)
Spectral regression
Sowell (1992)
Spectral analysis

Lo’s Modified R/S
Lack of robustness in R/S
In presence of short memory effects
Lo’s statistic replaces standard deviation
Uses consistent estimator of standard
deviation of partial sum of x
1/ 2
⎧⎪ T
2 q
j ⎛ T ⎞⎫⎪
sT (q ) = ⎨∑ ( xi − x ) / T + ∑
2
⎜ ∑ ( xi − x )( xi − j − x ) ⎟⎬
⎪⎩ i =1 T j =1 q + 1 ⎜⎝ i = j +1 ⎟⎪
⎠⎭

Comments on Lo’s Method
Lo shows modified R/S is robust to
short-range dependence
Teverlosky et al (1999)
Lo test tends to reject long range
dependence
Choice of truncation lag q is critical

Peng’s DFA Analysis
Distinguishes between long memory
and non-stationarities
Method
t′
Obtain integrated series y(t ′) = ∑

T =1
x(t )
Divide into non-overlapping intervals

Each containing m data points
Fit regression line to each interval

Peng’s DFA Analysis
Calculate fluctuation around regression
line ym(t)
[ ]
T
1
F ( m) = ∑
T t ′=1
′ ′
y (t ) − ym (t )]2
For series with long memory F(m) ∝ ma

a > 1/2

Geweke & Porter-Hudak
Spectral density regression
⎧ 2 ⎛ ωλ ⎞⎫
ln{I (ω λ )} = a + b ln ⎨4 sin ⎜ ⎟⎬ + ηλ
⎩ ⎝ 2 ⎠⎭
I(ωλ) is the periodogram at frequencies ωλ =
2πλ/T
λ =1, . . .,(T-1),T is #observations
The slope of the OLS regression provides estimate
of fractional differencing parameter d

Sowell Method
Calculates autocovariance in terms of spectral
density function f(w)
2π
1
γ (k ) =
2π ∫
0
f ( w)eiwk dw
Estimates ARFIMA model using maximum

likelihood
Includes fractional differencing parameter

ARFIMA Models
Generalized ARIMA models
ARFIMA(p,d,q)
Fractional differencing parameter d = H - 0.5
φ and θ are polynomials order p and q
φ ( L)(1 − L) yt = θ ( L)ε t
d
∞
Γ ( j − d ) L j
(1 − L) d = ∑
j = 0 Γ ( − d )Γ ( j + 1)
Models fractal Brownian motion
Short memory effects
Long memory effects
ARFIMA(1, d, 0)
Process: (1 - αLd) yt = εt
Combines long and short term memory
processes
Correlation function
(− d )!(1 + α ) k 2 d −1
ρk = ×
(d − 1)!(1 − α ) F (1,1 + d ;1 − d ;α )
2
F(a,b;C,z) is the Hypergeometric function

AR(1) vs ARFIMA(1,d,0)
ARCH Error Process εt
Parameters
1.5
1.0
d = 0.4
0.5
0.0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
a1 = 0.5
-0.5

-1.0
ARFIMA shocks are -1.5
ARMA vs ARFIMA Process
more persistent 2.5

2.0
1.5
1.0
0.5
0.0
-0.5
11
13
15
17
19
1
9
-1.0
-1.5
-2.0
-2.5
-3.0 ARMA ARFIMA

AR(1) vs. ARFIMA(1, d, 0)
Example: AR(1) vs. ARFIMA(1,d, 0)
0.8

0.7
AR(1): a = 0.711
0.6
ARFIMA(1, d, 0): d = 0.2, a = 0.5
Correlation
0.5
0.4
0.3
AR(1)
0.2 ARFIMA(1,d,0)
0.1
0.0
0 5 10 15 20 25
Lag

GARCH Models
AR(1) process: yt+1 = a0 + a1yt + εt+1
Conditional Forecast
Et(yt+1) = a0 + a1yt
Forecast Error Variance
Et[yt+1 - Et(yt+1)]2 = Et[yt+1 - (a0 + a1yt)]2 = Et(εt+1 )2 = σ2

Unconditional Forecast
Unconditional Expectation is Constant
E(yt+1) = a0 /(1 - a1)
i.e. the long run mean
Unconditional Variance is Constant
E[yt+1 - E(yt+1)]2 = E[yt+1 - a0 / (1 - a1)]2 = σ2 / (1 - a1)2
Unconditional forecast has greater variance
Since 1 / (1 - a1) > 1
Conditional Variance is Constant

Et(εt+12) = Et(yt+1 - a0 + a1yt )2 = σ2

ARCH Process
Suppose conditional variance is not constant
Model conditional variance as an AR(p) process
εt2 = α0 + α1 (εt-1)2 + α2 (εt-2)2 + . . . + αq (εt-q)2 + vt
vt is white noise
Multiplicative ARCH model (Engle):
εt2 = [α0 + α1 (εt-1)2] vt2
is white noise with σ2v = 1
εt are independent of each other
α0 > 0 and 0 < α1 < 1

Key Points about ARCH
Errors Moments
Zero mean, covariance, unconditional variance
Error variance fluctuates
For large εt , variance of εt will be large
Periods of tranquility & volatility in {y}
Errors are not independent
Related through second moment
Parameter values
Restricted to ensure variance > 0 and series is stable
α0 > 0 and 0 < α1 < 1
ARCH Example
A R C H E r r o r P r o c e ss ε t
Parameters
2 .0
1 .5
1 .0
α0 = 0.3, α1 = 0.9 0 .5
0 .0
a1 = 0.25 & 0.9

- 0 .5 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
- 1 .0
Effects & Interactions

- 1 .5
- 2 .0
- 2 .5
Larger α1, more ARCH Process yt = a 1yt-1 + ε t

persistent are shocks in
{εt}
2.0
1.0
Larger a1, more 0.0
persistent is change in
1
11
13
15
17
19
- 1.0
{yt} - 2.0
- 3.0
- 4.0 yt
y't
- 5.0

GARCH Models
GARCH(p, q)
Error Process εt = vt√ σt
vt is white noise No(0,1)
q p
σ = α 0 + ∑α ε
t
2 2
i t −i + ∑ β iσ 2
t −i
i =1 i =1
Error Process {εt}

Conditional mean and variance are zero
Conditional variance is σt2

Properties of GARCH
Disturbances of series {yt} follow ARMA process
ARMA(p, q) process in series {εt2}
q p
Et −1ε t2 = σ t2 = α 0 + ∑ α iε t2−i + ∑ β iσ t2−i
i =1 i =1
Estimating a GARCH Model
Fit ARMA model to series {yt}
Evaluate sample autocorrelations of squared residuals
Should suggest an ARMA(p, q) process in series {εt2}

ARFIMA-GARCH
Returns follow ARFIMA process
Volatility follows GARCH process
Example
ARFIMA(1,d,1)-GARCH(1,1)
(1 − φL)(1 − L) d yt = (1 − θL)ε t
σ t2 = α 0 + α1ε t2−1 + βσ t2−1

Fractionally Integrated GARCH
Baillie, Bollerslev, Mikkelsen (1996)
φ ( L )(1 − L ) ε = ω + [1 − β ( L )]v t
d
t
2
v t = ε t2 − σ t2
φ and β are polynomials order p and q
d is fractional differencing parameter
FI(p,d,q) is strictly stationary

GARCH vs FIGARCH
GARCH
Shocks to variance process die away at fast
exponential rate
FIGARCH
Shocks die away much more slowly
(hypergeometeric)
Has “long memory”

FIGARCH Research:
Stock indices
Grau-Carles (2000)
FIGARCH models for major indices
Volatility processes:
Absolute and squared returns
Estimated fractional differencing parameter
Hurst exponent
Detrended fluctuation analysis (Peng)
Sowell’s spectral density method

FIGARCH for Stock Indices
Index Estimated d*
DOW 0.27 – 0.31
SP500 0.32 – 0.37
FTSE 0.11 – 0.17
NIKKEI 0.29 - 0.42
* based on absolute returns
Conclusion:
Compelling evidence of long range autocorrelations
in stock index volatility

Volatility Direction Prediction
ARFIMA-GARCH models
Account for 50% of variation in conditional
volatility
Sign prediction
Varies, but 70% is typical
Highly statistically significant
Pesaran-Timmerman sign test

Pesaran-Timmerman Test
Test of market timing ability
Based on correct sign predictions
Test statistic ~ No(0,1)
Pˆ − P* 1 T
Sn = 2
{σ Pˆ − σ Pˆ }
ˆ ˆ 2 1/ 2 Pˆ = ∑
T − T1 t =1
zt + n
*
zt+n = 1 if (yt+n ft,n )>0; 0 otherwise

P* = pr(zt+n = 1) = pr (yt+n ft,n )> 0 = PyPf + (1-Py)(1-pf)
Py = pr(yt+n > 0) ; pf = pr(ft,n > 0 )

Volatility Direction Prediction
Volatility Direction Forecast Accuracy
100%
90%
80%
70%
60%
50%
BMY CCE GE
IBM JNJ SP500
40%
90 91 92 93 94 95 96 97 98 99 00 01

Economic Value of
Volatility Forecasting
Fleming, Kirby & Ostdiek, 2000
Addresses issue of whether volatility forecasting is
economically worthwhile
Stocks, bonds, gold and cash
Volatility timing strategies
Re-estimate conditional covariances every period
Consistently outperform static strategies
in 84% - 92% of trials
Sharpe ratio ~ 0.85

Stochastic Volatility Models
Asset process S with instantaneous drift
µ and volatility σ
Both drift and volatility depend on
latent state variable v which also
evolves as a diffusion
dSt = µ ( St ,ν t ) + σ ( St ,ν t )dWSt
dν t = α ( St ,ν t ) + β ( St ,ν t )dWνt

Streamlined Model
Log volatility is the state variable
Evolves as a mean-reverting Ornstein-
Uhlenbeck process
dS t
= µdt + σ t dW St
St
d ln σ t = α (ln σ − ln σ t )dt + βdW νt

Euler Discretized Model
st = st − ∆t + σ iH ε st ∆t
ln σ ( i +1) H = ln σ + ρ H (ln σ iH − ln σ ) + βε vi H
Where iH < t <= (i+1)H

εst and εvt are independent N[0,1]
innovations

Multifactor Models
ln σ (i +1) H = ln σ + ln σ 1,( i +1) H + ln σ 2,( i +1) H
ln σ 1,(i +1) H = ρ1, H ln σ 1,iH + β1 Hν 1,( i +1) H

ln σ 2,( i +1) H = ρ 2, H ln σ 2,iH + β 2 Hν 2,( i +1) H
Volatility component innovations v1 and

v2 are independent N[0,1] variates
Applying Multifactor Models
Alizadeh, Brandt, Diebold (2001)
Apply single and multifactor models
Using log range
GBP, CAN$, DM, YEN, SFr
Single factor models
Poor fit
Long term autocorrelations in residuals
Unable to account for long memory

Multifactor Models Results
CURR lnσbar ρ1 β1 ρ2 β2
GBP -2.5 .98 .94 .19 5.14
CAD -3.34 .98 1.2 .16 4.26
DM -2.47 .97 1.23 .05 4.64
YEN -2.53 .97 1.43 .15 5.68
SFr -2.32 .97 1.05 .03 4.50

Multifactor EGARCH models
Brandt & Jones (2002)
Multifactor log-range REGARCH models
Allow for volatility asymmetry
Applied to SP500 index
Outperform single factor models and
multifactor models based on log returns

Conclusions on
Multifactor Models
Volatility model must explain two factors
Persistent volatility (autocorrelation)
Transient Volatility (volatility of volatility)
Single factor models mis-specify
Significant gains to using log range
Normality
Greater efficiency
Better at modeling the Vvol

Fokker-Planck Models
Assume stochastic volatility model
dσ = α (σ )dt + β (σ )dW
Then (to leading order)
(δσ ) = β (σ ) φ δt
2 2 2
([ ])
ln E (δσ ) 2 = 2 ln (β (σ ) ) + ln(δt ) = a + b ln(σ )
From regression, we can estimate β (σ ) = νσ γ

Estimating the Volatility Drift
Fokker-Planck equation
∂p 1 ∂ 2 ∂
= ( β p) −
2
(α p)
∂t 2 ∂σ 2
∂σ
P(σ,t) is the pdf of σ
Steady state distribution p∞(σ,t)
1 ∂2 ∂
0= ( β p∞ ) −
2
(α p∞ )
2 ∂σ 2
∂σ
Hence α (σ ) = 1 d ( β 2 p )
∞
2 p∞ dσ
The Steady State Distribution
p∞ is approximately lognormal
1 ( −1 / 2 a 2 )(ln(σ / σ )) 2
p∞ = e
2π aσ
Hence drift
2γ −1 ⎛ 1 1 ⎞
α (σ ) = ν σ 2
⎜ γ − − 2 ln(σ / σ ) ⎟
⎝ 2 2a ⎠
Fokker-Planck Simulation
Fokker-Planck Volatility Model
30%
25%
20%
15%
10%
5%
0%

Multivariate Volatility Models
Relationships between volatility
processes
Cointegration and fractional
cointegration

Bi-Variate GARCH & FIGARCH
Bi-variate GARCH(1,1) Bollerslev (1990)
Bi-variate FIGARCH, Brunetti & Gilbert (1998)
E.g. bi-variate FIGARCH (1,d,1)
ωj
σ 2
= λ jj ( L )ε 2
+
1 − β jj (1)
jj ,t j ,t
σ ij2 ,t = ρ[σ ii2 ,t , σ 2jj ,t ]1/2
λ jj = 1 − {[(φ jj ( L ))(1 − L ) ]/[1 − β jj ( L )]}

d j

Multivariate FIGARCH
General Form
Φ( L)∆ ε = ω + (Ι − Β ( L)) ν t
t
2
Where ∆ has diagonal elements (1-L)dj

Cointegration
Granger (1986) and Engle (1987)
General idea:
Processes that “move together”
Individually non-stationary
Some (linear) function of them is stationary
Example
Spot & futures prices
Individually non-stationary
Difference (basis) is stationary

Cointegration –
Formal Definition
Components of vector yt are said to be
cointegrated of order (d, b) if
All components of are integrated of order d > 0
Ldyt is stationary
There exists vector β = (β1, β2, . . . βν) such that
β1y1t + β2y2t + . . . + βnynt is I(d-b)
b>0
Vector β is called cointegrating vector

Cointegration Examples
Forward rates
Expectations theory Et[st+1] = ft
Error process εt+1 = st+1 – ft
{εt+1} must be a stationary process

Otherwise arbitrage
Even though {st} and {ft} are nonstationary I(1) processes
Currencies: Purchasing Power Parity
Difference in real exchange rates must be stationary
Econometric models in general
e.g. Money demand as linear function of prices, real
income and interest rate
Example: CI(1,1,) System
Two random walk processes
yt = µt + εyt
zt = µt + εzt
µt is random walk representing trend
Processes yt and zt are I(1)
Cointegrated C(1,1) process because:
(yt - zt) = εit is stationary error process I(0)
Cointegrating vector (1,-1)

Example: CI(1,1) System
CI(1,1) Process
yt = µ t + ε yt
10.0 zt = µ t + ε yt
µ t = µ t- 1 + ε t
8.0
6.0
4.0
2.0
0.0
0 5 10 15 20
-2.0
-4.0
-6.0

Error Process is Stationary
Error Process {yt - zt}
2.0
1.5
1.0
0.5
0.0
1 6 11 16
- 0.5
- 1.0
- 1.5
- 2.0
- 2.5
- 3.0

Scatter Plot of System
Variables
Scatter Plot of System Variables
2 .0 y = 0 .4179x - 0.5 24
R2 = 0.435 5
1 .5
1 .0
0 .5
0 .0
-4.0 - 3.0 -2.0 -1.0 0.0 1.0 2.0 3.0 4.0 5.0
Z(t )
-0 .5
-1 .0
-1 .5
-2 .0
-2 .5
-3 .0
Y( t)

Fractional Cointegration
Robinson & Marinucci (1989)
Chueng & Lai (1993)
Baillie & Bollerslev (1994)
Parent series may be fractionally integrated
Sub-process may also be fractionally
cointegrated

Implications for Investment
Volatility processes fractionally cointegrated
Divergences in volatilities less persistent than
the volatilities themselves
Implication:
Opportunities for statistical arbitrage between
cointegrated volatility markets
Entails relatively low degree of risk

Investment Strategy
Volatility Models
Identify key factors underlying volatility
Identify key stock volatility processes
Within a defined group, e.g. DOW 30
Stock Selection
Identify stock baskets with cointegrated
volatility processes

Modeling Procedure
Estimate fractional order of vol processes
Using univariate FIGARCH models
Test hypothesis that fractional integration
parameters are equal
Estimate linear cointegrating vector
Test for fractional cointegration

Example: NYMEX - IPE

Modeled variance as:
Absolute returns
Squared returns
Estimate ARFIMA models for two volatility
processes
Find common fractional integration ~ 0.2
Model difference in volatility processes
i.e cointegrating vector is (1,-1)
Find it is cointegrated I(0)
IPE volatility reacts to shocks in NYMEX volatility
more strongly than NYMEX reacts to IPE
Identifying Cointegrated
Volatility Processes
Exploratory Multivariate Analysis
Cluster Analysis
Factor Analysis
Regression Analysis
Fractional Cointegration Analysis
Fit FIGARCH models to volatility processes
Test for cointegration
Estimate cointegrating vector

Cluster Analysis
Tree Diagram for Variables
Single Linkage
Euclidean distances
DJIA
Primary grouping:
GE
IP
MMM
DD
Capital goods/
XOM
UTX
KO
PG
HON
DIS
MCD
AA
MRK
MO
EK
CAT
BA
GM
WMT
IBM
AXP
JPM
SBC
T
C
JNJ
HWP
HD
MSFT
INTC
13 14 15 16 17 18 19 20 21 22
Linkage Distance

Factor Models
Plot of Eigenvalues
14
13
12 “Raw Materials & Cap Goods”:

11
10
XOM, DD, IP, AA, MMM, GE, CAT
9
8 “New Technology”:
MSFT, INTC
Value
“Finance & Technology:

6
4 C, AXP, JPM, HWP, T

“Drugs & Consumer Goods”:
3
1 MRK, JNJ, PG, MO, KO, MCD

0
Number of Eigenvalues

Factor Models
Factor Loadings, Factor 1 vs. Factor 2
Rotation: Varimax raw
Extraction: Principal components
0.8
BA
UTX
0.6
DIS
WMT MCD HON
DJIA
JPM
0.4 AXP GE
AA IP
MMM XOM
Factor 2
JNJ HDHWP
0.2 MO KO DD
SBC GM
C INTC
MRK PG CAT
EK
MSFT
IBM
0.0
-0.2 T
-0.4
-0.2 -0.1 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7
Factor 1

Regression-
Cointegration Models
Predicted vs. Observed Values
Dependent variable:DJIA
DJIA
6

5
DD 4
GE 3
IP
Observed Values

2
MMM 1
MRK 0
UTX -1
XOM -2
R2 = 78% -3
-2 -1 0 1 2 3 4 5 6
Predicted Values 95% confidence

Volatility Portfolio Construction
Volatility modeling & forecasting
FIGARCH models
For cointegrated volatility processes
Portfolio optimization
Risk adjusted return
Market neutrality & other constraints
Hedging
Platinum hedge

Summary
Key theoretical concepts
Volatility measures
Long Memory
FIGARCH & Multifactor models
Volatility cointegration

References
Andersen, Bollerslev, Diebold, Labys (2001)
Modeling and forecasting realized volatility, 2001
Realized volatility & correlation, 1999
Lien & Yiu Kuen Tse (1999)
Forecasting the Nikkei Spot Index with fractional cointegration, Journal
of Economterics (1999)
Bollerslev, Mikkelsen (1996)
Modeling & pricing long memory in stock market volatility, Journal of
Economterics
Lamoureaux & Lastrapes (1990)
Persistence in variance, structural change and the GARCH model
Journal of Business and Economic Statistics 8 pp225-235

References
Bivariate FIGARCH and fractional cointegration, Journal of Empirical
Finance 7 pp509-530
Grau-Carles (2000)
Empirical evidence of long-range correlations in stock returns, Physica A
287 pp396-404

Heterogeneous information arrivals and return volatility dynamics,
Journal of Finance 52

Risk Management Volatility

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Volatility Modeling

Copyright © 2000 – 2006

Copyright 2001-2006 Investment Analytics Volatility Slide: 2

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120% DJIA IBM INTC IP JNJ

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 Where s* is standardized diffusion with unit volatility

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 γ only scales proxy, does not affect distribution

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 Garman & Klass (7 x efficiency)

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 Random Walk without drift

 Integrated process, order 1

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 Ei is a strict white noise process, No(0, 1)

Copyright 2001-2006 Investment Analytics Volatility Slide: 49

 Compute average for each sub-period ra = ∑ rak

 Define range Ra = Max(Xk,a) - Min(Xk,a)

 Use OLS Regression to Estimate H

3.0 y = 0.843x - 0.825

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 Obtain integrated series y(t ′) = ∑

 Divide into non-overlapping intervals

Copyright 2001-2006 Investment Analytics Volatility Slide: 57

Where s* is standardized diffusion with unit volatility

γ only scales proxy, does not affect distribution

Garman & Klass (7 x efficiency)

Random Walk without drift

Integrated process, order 1

Ei is a strict white noise process, No(0, 1)

Compute average for each sub-period ra = ∑ rak

Define range Ra = Max(Xk,a) - Min(Xk,a)

Use OLS Regression to Estimate H

Obtain integrated series y(t ′) = ∑

Divide into non-overlapping intervals

For series with long memory F(m) ∝ ma

Estimates ARFIMA model using maximum

F(a,b;C,z) is the Hypergeometric function

ARFIMA shocks are -1.5

Conditional Variance is Constant

Larger α1, more ARCH Process yt = a 1yt-1 + ε t

Error Process {εt}

zt+n = 1 if (yt+n ft,n )>0; 0 otherwise

Where iH < t <= (i+1)H

Volatility component innovations v1 and

Applied to SP500 index

Outperform single factor models and

Where ∆ has diagonal elements (1-L)dj

Error process εt+1 = st+1 – ft

{εt+1} must be a stationary process