Risk Management > Volatility | Stationary Process | Volatility (Finance)

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

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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
Copyright 2001-2006 Investment Analytics Volatility Slide: 3

Thick Tails, Non-Normal Distribution
Mandelbrot (1963), Fama (1963, 1965)

Skewness = -0.6 Kurtosis = 5.7

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Volatility

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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)

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Volatility

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Volatility is Stochastic
Volatility - DOW Stocks
140% 120% 100% 80% 60% 40% 20% 0% 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
DJIA IBM INTC IP JNJ

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Volatility

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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

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Volatility

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The Volatility Cone

Volatility(%)

Maximum
Average

Minimum 0 30 60

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Days

Volatility

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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)
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Volatility Seasonality
DOW Volatility Seasonality
160%

140%

120%

100%

80%

60%

40% JAN

FEB

MAR

APR

MAY

JUN

JUL

AUG

SEP

OCT

NOV

DEC

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Volatility

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Volatility Correlation
Volatilities tend to change together
Stocks: Black (1976) FX: Diebold & Nerlove (1989)

Also across markets
Stock & bond volatilities move together (Schwert, 1989)

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Volatility

Slide: 11

Volatility Correlation
Correlation: IBM vs JNJ Volatility
1.2 1.0

0.8

0.6

0.4

0.2

0.0

May-85
-0.2

May-88

May-91

May-94

May-97

May-00

-0.4

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Volatility

Slide: 12

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.)

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Volatility

Slide: 13

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

γ

Where s* is standardized diffusion with unit volatility

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Volatility

Slide: 14

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

-10

-8

-6

-4

-2

0

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Volatility

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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)
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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 ⎞ ⎟ ⎜ ⎠ ⎝ Convergence:
h h h t + h ,t t+ t+ =0 0 t+ 0 t+

∑r
j

t + j∆ , ∆

• rt′+ j∆ ,∆ − ∫ Ω t +τ dτ → 0
0

h

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Volatility

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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%
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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 X <= Category Boundary -1 -0.8 -0.6 -0.4 -0.2 0

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Volatility

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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)

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Volatility

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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 ⎦

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Volatility

Slide: 22

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

Garman & Klass (7 x efficiency)
ABS[

σ =

1 N

1 [ L n ( H i / L i )] 2 − 2

1 N

( 2 L n ( 2 ) − 1 )[ L n ( C i / C i − 1 )] 2 ]

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Volatility

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Properties of Log Range
Distribution
Very close to Normal
Dt ~N[0.43 + lnht, 0.292] Typical skewness 0.28, kurtosis 3.2
Where ht = σ / 2521/2

Efficiency
Stdev approx ¼ of log abs return

Robustness
Not affected by bid/ask bounce to same degree as realized volatility
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Log Range for SP500 Index
Log Range SP500 Index Jan 1983- Jul 2002
X <= -5.5026 5.0% 0.8 X <= -3.6733 95.0% 0.7

0.6 0.5

0.4

0.3

0.2 0.1

0 -7 -6 -5 -4 -3 -2 -1

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Volatility

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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 No. of obs. 30 25 20 15 10 5 0 -3.5 -3 -2.5 -2 -1.5 -1 X <= Category Boundary

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Volatility

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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 5-min 40-min 12 hour
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Realized 9.35 3.72 1.79
Volatility

Range 2.11 1.87 0.68
Slide: 28

Volatility Models
Key volatility characteristics
Long memory Volatility of volatility

Univariate models Multivariate models

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Volatility

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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

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Volatility

Slide: 30

White Noise
Mean is constant (zero)
E(εt) = µ (0)

Variance is constant
Var(εt) = E(εt2) = σ2

Uncorrelated

Gaussian White Noise Strict White Noise
εt are independent
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Cov(εt , εt-j) = 0 for j < > 0 and t If εt is also normally distributed

Volatility

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Stationarity
Weak (covariance) stationarity
Population moments are time-independent: E(yt) = µ Example: white noise εt In addition, yt is normally distributed
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Var(yt) = σ2 Cov(yt, yt-j) = γj

Strong stationarity

Stationary Series

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Volatility

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Stationarity of AR(1) Process
AR(1) Process: yt = a0 + a1yt-1 + εt Expected value E(yt) is time-dependent:

E ( yt ) = a0 ∑ a + a y 0
i =0 i 1 t 1

t −1

If |a1| < 1, then as t →∞, process is stationary
Lim E(yt) = a0 / (1 - a1) Also Var(yt) = σ2/[1 - (a1)2] And Cov(yt, ys) = σ2 (a1)s /[1 - (a1)2]
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Hence mean of yt is finite and time independent

Slide: 34

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

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Volatility

Slide: 35

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 t≠s ⎣1 ⎦
Copyright 2001-2006 Investment Analytics Volatility Slide: 36

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)

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Volatility

Slide: 37

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

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Volatility

Slide: 38

Long Memory
Idea: shocks persist over long time period Long Memory autocorrelation function
Hyperbolic decay

ρ (t ) ~ L(t )t
| ρ (t ) |≤ Cr
|t |

2 d −1

Short Memory autocorrelation function

1 as t → ∞, 0 < d < 2

for some C > 0,

0 < r <1

ARMA models only have short memory
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Volatility Long Memory
Volatility is highly persistent Events have sustained influence on future volatility In principle, process is very forecastable

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Volatility

Slide: 40

Volatility Autocorrelations
Volatility Autocorrelations
0.5 0.4 0.3 0.2 0.1 0.0 1 -0.1 4 7 10 13 16 19 22

DJIA BA DD GE HWP IBM

Months
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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
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Theories of Long Memory in Volatility
Andersen & Bollerslev (1997)
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
Copyright 2001-2006 Investment Analytics Volatility Slide: 43

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
Volatility Slide: 44

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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
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White Noise Process
Fractal Random Walk
20 0

-20

-40

-60

-80

H = 0.5

-100

-120

-140

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Volatility

Slide: 46

Black Noise Process
Fractal Random Walk
100 0

-100

-200

-300

H = 0.9
Smoother series Trend

-400

-500

-600

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Volatility

Slide: 47

Pink Noise Process
Fractal Random Walk
15 10 5 0 -5 -10 -15 -20 -25 -30 -35

H = 0.1
More volatile Antipersistent
Mean reverting
Volatility Slide: 48

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Simulating A Fractal Random Walk
Feder (1988):
n(M−1) ⎛ n−H ⎞ ⎧ nt (H−0.5) ⎫ (H−0.5) (H−0.5) ∆yH (t) = ⎜ −i E(1+n(M+1)−i) + ∑ (n+i) E(1+n(M−1+t)−i) ⎬ ⎜ Γ(H +0.5) ⎟×⎨∑i ⎟ 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
Copyright 2001-2006 Investment Analytics Volatility Slide: 49

Calculating (R/S)
Form series of returns
rt = Ln(Pt / Pt -1) for t = 1, 2, . . . , T

Divide into A contiguous sub-periods Compute average for each sub-period ra = ∑ rak k =1 Form cumulative series
Length n, such that An = T
n

X ka = ∑ (ria − ra )
i =1

k

Define range Ra = Max(Xk,a) - Min(Xk,a)
Copyright 2001-2006 Investment Analytics Volatility Slide: 50

Calculating (R/S)
Compute standard deviation
⎡1 S a = ⎢ ∑ (rka − ra ) ⎢ n k =1 ⎣
n 2 1/ 2

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)
Copyright 2001-2006 Investment Analytics Volatility Slide: 51

Volatility R/S Analysis
GE - Rescaled Range Analysis
3.5 3.0 2.5
Ln(R/S)

y = 0.843x - 0.825 R2 = 99%

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)

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Volatility

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

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Volatility

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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
Copyright 2001-2006 Investment Analytics Volatility Slide: 54

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
⎧ ⎞⎫ 2 j ⎛ ⎪ 2 ⎜ ∑ ( xi − x )( xi − j − x ) ⎟⎪ sT (q ) = ⎨∑ ( xi − x ) / T + ∑ ⎟⎬ T j =1 q + 1 ⎜ i = j +1 ⎪ i =1 ⎝ ⎠⎪ ⎩ ⎭
T q T 1/ 2

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Volatility

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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

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Volatility

Slide: 56

Peng’s DFA Analysis
Distinguishes between long memory and non-stationarities Method
Obtain integrated series y(t ′) = ∑ x(t ) T =1 Divide into non-overlapping intervals
Each containing m data points
t′

Fit regression line to each interval

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Volatility

Slide: 57

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

[

]

a > 1/2

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Volatility

Slide: 58

Geweke & Porter-Hudak
Spectral density regression

⎧ 2 ⎛ ωλ ln{I (ω λ )} = a + b ln ⎨4 sin ⎜ ⎝ 2 ⎩

⎞⎫ ⎟⎬ + ηλ ⎠⎭

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

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Volatility

Slide: 59

Sowell Method
Calculates autocovariance in terms of spectral density function f(w)

1 γ (k ) = 2π

∫ f (w)e
0

iwk

dw

Estimates ARFIMA model using maximum likelihood Includes fractional differencing parameter

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Volatility

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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

Models fractal Brownian motion
Short memory effects Long memory effects
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Γ( j − d ) L j (1 − L) d = ∑ j = 0 Γ ( − d )Γ ( j + 1)

ARFIMA(1, d, 0)
Process: (1 - αLd) yt = εt Correlation function
Combines long and short term memory processes
2 d −1

(− d )!(1 + α ) k ρk = × 2 (d − 1)!(1 − α ) F (1,1 + d ;1 − d ;α )
F(a,b;C,z) is the Hypergeometric function

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Volatility

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

ARCH Error Process εt

ARFIMA shocks are more persistent

ARMA vs ARFIMA Process
2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 ARMA ARFIMA

17

11

13

15

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Volatility

19

1

3

5

7

9

Slide: 63

AR(1) vs. ARFIMA(1, d, 0)
0.8 0.7 0.6

Example: AR(1) vs. ARFIMA(1,d, 0)
AR(1): a = 0.711 ARFIMA(1, d, 0): d = 0.2, a = 0.5

Correlation

0.5 0.4 0.3 0.2 0.1 0.0

AR(1)
ARFIMA(1,d,0)

0

5

10 Lag

15

20

25

Copyright 2001-2006 Investment Analytics

Volatility

Slide: 64

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

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Volatility

Slide: 65

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
Copyright 2001-2006 Investment Analytics Volatility Slide: 66

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

Copyright 2001-2006 Investment Analytics

Volatility

Slide: 67

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
Copyright 2001-2006 Investment Analytics Volatility Slide: 68

ARCH Example
Parameters Effects & Interactions
Larger α1, more persistent are shocks in {εt} Larger a1, more persistent is change in {yt} α0 = 0.3, α1 = 0.9 a1 = 0.25 & 0.9
A R C H E r r o r P r o c e ss ε
2 .0 1 .5 1 .0 0 .5 0 .0 - 0 .5 - 1 .0 - 1 .5 - 2 .0 - 2 .5 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
t

ARCH Process yt = a 1yt-1 + ε t
2.0 1.0 0.0

1

3

5

7

9

11

13

15

17

- 1.0 - 2.0 - 3.0 - 4.0 - 5.0

19

yt

y't

Copyright 2001-2006 Investment Analytics

Volatility

Slide: 69

GARCH Models
GARCH(p, q)
Error Process εt = vt√ σt vt is white noise No(0,1)

σ = α 0 + ∑α ε
2 t i =1

q

2 i t −i

+ ∑ β iσ
i =1

p

2 t −i

Error Process {εt}
Conditional mean and variance are zero Conditional variance is σt2
Copyright 2001-2006 Investment Analytics Volatility Slide: 70

Properties of GARCH
Disturbances of series {yt} follow ARMA process
ARMA(p, q) process in series {εt2}
q

Et −1ε t2 = σ t2 = α 0 + ∑ α iε t2−i + ∑ β iσ t2−i
i =1 i =1

p

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}

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Volatility

Slide: 71

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

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Volatility

Slide: 72

Fractionally Integrated GARCH
Baillie, Bollerslev, Mikkelsen (1996)

φ ( L )(1 − L ) ε = ω + [1 − β ( L )]v t
d 2 t

v t = ε −σ
2 t

2 t

φ and β are polynomials order p and q d is fractional differencing parameter

FI(p,d,q) is strictly stationary
Copyright 2001-2006 Investment Analytics Volatility Slide: 73

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”

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Volatility

Slide: 74

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

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Volatility

Slide: 75

FIGARCH for Stock Indices
Index DOW SP500 FTSE NIKKEI Conclusion:
Compelling evidence of long range autocorrelations in stock index volatility
Copyright 2001-2006 Investment Analytics Volatility Slide: 76

Estimated d* 0.27 – 0.31 0.32 – 0.37 0.11 – 0.17 0.29 - 0.42
* based on absolute returns

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

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Pesaran-Timmerman Test
Test of market timing ability
Based on correct sign predictions

Test statistic ~ No(0,1)

ˆ P − P* Sn = 2 ˆ P − σ P }1/ 2 ˆ2 {σ ˆ ˆ
*

ˆ P=

1 ∑ zt + n T − T1 t =1

T

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 )
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Volatility Direction Prediction
Volatility Direction Forecast Accuracy
100%

90%

80%

70%

60%

50%

BMY IBM
40%

CCE JNJ
97 98 99

GE SP500
00 01

90

91

92

93

94

95

96

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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
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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
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Streamlined Model
Log volatility is the state variable Evolves as a mean-reverting OrnsteinUhlenbeck process

dS t = µdt + σ t dW St

St

d ln σ t = α (ln σ − ln σ t )dt + βdW νt

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

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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

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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
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Fokker-Planck Models
Assume stochastic volatility model

dσ = α (σ )dt + β (σ )dW
Then (to leading order)

ln E (δσ ) 2 = 2 ln (β (σ ) ) + ln(δt ) = a + b ln(σ )
From regression, we can estimate β (σ ) = νσ γ
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([

(δσ ) = β (σ ) φ δt
2 2 2

])

Estimating the Volatility Drift
Fokker-Planck equation ∂p 1 ∂ 2 ∂ 2 = ( β p) − (α p) 2 ∂t 2 ∂σ ∂σ
P(σ,t) is the pdf of σ

Steady state distribution p∞(σ,t)
∂ 1 ∂2 2 0= ( β p∞ ) − (α p∞ ) 2 2 ∂σ ∂σ Hence α (σ ) = 1 d ( β 2 p ) ∞ 2 p∞ dσ
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The Steady State Distribution
p∞ is approximately lognormal

p∞ =

1 2π aσ
2 2γ −1

e

( −1 / 2 a 2 )(ln(σ / σ )) 2

Hence drift
α (σ ) = ν σ
Copyright 2001-2006 Investment Analytics

1 1 ⎛ ⎞ ⎜ γ − − 2 ln(σ / σ ) ⎟ 2 2a ⎝ ⎠
Volatility Slide: 91

Fokker-Planck Simulation
Fokker-Planck Volatility Model
30%

25%

20%

15%

10%

5%

0%

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Multivariate Volatility Models
Relationships between volatility processes Cointegration and fractional cointegration

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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)

σ

2 jj ,t

= λ jj ( L )ε

2 j ,t

ωj + 1 − β jj (1)
d
j

2 2 σ ij ,t = ρ[σ ii ,t , σ 2 ,t ]1/2 jj

λ jj = 1 − {[(φ jj ( L ))(1 − L ) ]/[1 − β jj ( L )]}
Copyright 2001-2006 Investment Analytics Volatility Slide: 94

Multivariate FIGARCH
General Form

Φ( L)∆ ε = ω + (Ι − Β ( L)) ν t
2 t

Where ∆ has diagonal elements (1-L)dj

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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

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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
Copyright 2001-2006 Investment Analytics Volatility Slide: 97

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
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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)

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Example: CI(1,1) System
CI(1,1) Process
10.0 8.0 6.0 4.0 2.0 0.0 0 -2.0 -4.0 -6.0 5 10 15 20

yt = µ t + ε yt zt = µ t + ε yt µ t = µ t- 1 + ε t

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

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

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

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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

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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

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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

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Example: NYMEX - IPE

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Brunetti & Gilbert (2000)
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
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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
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Cluster Analysis
Tree Diagram for Variables Single Linkage Euclidean distances DJIA GE IP MMM DD 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

Primary grouping: Capital goods/

20

21

22

Linkage Distance

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Factor Models
Plot of Eigenvalues 14 13 12 11 10 9 8 Value 7 6 5 4 3 2 1 0 Number of Eigenvalues

“Raw Materials & Cap Goods”: XOM, DD, IP, AA, MMM, GE, CAT “New Technology”: MSFT, INTC “Finance & Technology: C, AXP, JPM, HWP, T “Drugs & Consumer Goods”: MRK, JNJ, PG, MO, KO, MCD
Volatility Slide: 111

Copyright 2001-2006 Investment Analytics

Factor Models
Factor Loadings, Factor 1 vs. Factor 2 Rotation: Varimax raw Extraction: Principal components 0.8 BA UTX 0.6

DIS WMT JPM

MCD

HON DJIA GE AA MMM IP XOM DD

0.4 Factor 2

AXP HDHWP C MSFT

0.2

JNJ

MO SBC INTC PG MRK

GM

KO CAT EK 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

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RegressionCointegration Models
DJIA
DD GE IP MMM MRK UTX XOM
Predicted vs. Observed Values Dependent variable:DJIA 6 5 4 3 Observed Values 2 1 0 -1 -2 -3 -2 -1 0 1 2 Predicted Values 3 4 5 95% confidence 6

R2 = 78%

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Volatility Portfolio Construction
Volatility modeling & forecasting
FIGARCH models
For cointegrated volatility processes

Portfolio optimization
Risk adjusted return Market neutrality & other constraints

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

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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

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References
Brunetti & Gilbert (2000)
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

Andersen & Bollerslev (1997)
Heterogeneous information arrivals and return volatility dynamics, Journal of Finance 52

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