Volatility and Correlation
CHAPTER 3
Introduction
It is important for a financial institution to monitor the volatilities of the market
variables (interest rates, exchange rates, equity prices, commodity prices, etc.)
on which the value of its portfolio depends.
A variable’s volatility, σ, is defined as the standard deviation of the return
provided by the variable per unit of time when the return is expressed using
continuous compounding.
When volatility is used for option pricing, the unit of time is usually one year, so
that volatility is the standard deviation of the continuously compounded return
per year.
When volatility is used for risk management, the unit of time is usually one day
so that volatility is the standard deviation of the continuously compounded
return per day.
Volatility
Define Si as the value of a variable at the end of day i.
The continuously compounded return per day for the variable on day i is
This is almost exactly the same as:
An alternative definition of daily volatility of a variable is therefore the standard
deviation of the proportional change in the variable during a day.
Volatility (Recap)
Z-table [cross-verify reading from the table below]
𝑥−𝜇
𝑍 − 𝑠𝑐𝑜𝑟𝑒 =
𝜎
Volatility (Recap)
Z-table:
+/- 1 𝜎 encompasses about 68.27% of the total area under the curve
+/- 2 𝜎 encompasses about 95.45% of the total area under the curve.
+/- 3 𝜎 encompasses about 99.73% of the total area under the curve.
Try It Yourself:
+/- 1.96 𝜎 encompasses about 95% of the total area under the curve.
Volatility (Recap)
Suppose that an asset price is $60 and that its daily volatility is 2%.
This means that a one standard-deviation move in the asset price over one day
would be 60 × 0.02 or $1.20.
If we assume that the change in the asset price is normally distributed, we can
be 95% certain that the asset price will be between 60 − 1.96 × 1.2 = $57.65 and
60 + 1.96 × 1.2 = $62.35 at the end of the day.
This is what is referred to as a two-tailed test, where there is a 2.5% probability
in each of the upper and lower tails of the distribution.
Volatility (Recap)
Uncertainty increases with the square root of time
Assume that the returns each day are independent with the same variance
Variance of the return over T days = T * Variance of the return over one day
Standard deviation of the return over T days = √T * Standard deviation of the
return over one day
Volatility (Recap)
Assume that an asset price is $60 and the volatility per day is 2%.
The standard deviation of the continuously compounded return over five days is
√5 × 2 or 4.47%.
Because five days is a short period of time, this can be assumed to be the same
as the standard deviation of the proportional change over five days.
A one-standard deviation move would be 60 × 0.0447 = 2.68.
If we assume that the change in the asset price is normally distributed, we can
be 95% certain that the asset price will be between 60 − 1.96 × 2.68 = $54.74
and 60 + 1.96 × 2.68 = $65.26 at the end of the five days.
Variance Rate
Risk managers often focus on the variance rate rather than the volatility.
The variance rate is defined as the square of the volatility.
The variance rate per day is the variance of the return in one day.
Whereas the standard deviation of the return in time T increases with the
square root of time, the variance of this return increases linearly with time.
Business Days vs Calendar Days
Research shows that volatility is much higher on business days than on non-
business days.
As a result, analysts tend to ignore weekends and holidays when calculating and
using volatilities.
The usual assumption is that there are 252 days per year.
Food for Thought: What causes volatility? [Read Business Snapshot 10.1, RMFI
page 216]
New Information
Trading Itself!
Business Days vs Calendar Days
Assuming that the returns on successive days are independent and have the
same standard deviation, this means that:
the daily volatility is about 6% of annual volatility.
Implied Volatilities
Although risk managers usually calculate volatilities from historical data, they
also try and keep track of what are known as implied volatilities.
The one parameter in the Black–Scholes–Merton option pricing model that
cannot be observed directly is the volatility of the underlying asset price.
The implied volatility of an option is the volatility that gives the market price of
the option when it is substituted into the pricing model.
