Risk Management

VOLATILITY

Dr. Ika Pratiwi Simbolon

Reference:
Hull, John C. 2012. Risk Management and Financial Institutions
Learning Outcomes
• To understand the definition of the volatility.
• To understand the variance rate.
• To understand the business days vs.
calendar days
• To understand the daily percentage
changes in financial variables normal.
• To understand the monitoring daily volatility
 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.
 Volatility is not constant.

During some periods, volatility is

relatively low, while during other
periods it is relatively high.
DEFINITION OF VOLATILITY
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.
  
•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

ln

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.

This is the definition that is usually used in

risk management.
EXAMPLE 1
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 ?
EXAMPLE 1
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.
Example 2
Continue that case with confidence
level of 90%.
• 
Ifwe assume that the returns each day are
independent with the same variance, the
variance of the return over T days is T times
the variance of the return over one day.

.T

This means that the standard deviation of the

return over T days is?
• 
= =

This means that the standard deviation of the

return over T days is √T times the standard
deviation of the return over one day.

This is consistent with the adage “uncertainty

increases with the square root of time.”
EXAMPLE 2
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 ?
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 ?

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
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.
Case
Assume that an asset price is $55
and the volatility per day is 2.2%.
With the confidence level 99%, the
asset price will be between?
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.

If we wanted to be pedantic, we could say

that it is correct to talk about the variance
rate per day, but volatility is “per square root
of day.”
Business Days vs. Calendar Days
One issue is whether time should be measured in
calendar days or business days.

Research shows that volatility is much higher on

business days than on non-business days.

The usual assumption is that there are 252 days

per year.
As a result, analysts tend to ignore
weekends and holidays when
calculating and using volatilities.

Why the volatility quite high in

weekends and holidays?
What Causes Volatility?
What Causes Volatility?

It is natural to assume that the volatility of a stock

or other asset is caused by new information
reaching the market.

This new information causes people to revise

their opinions about the value of the asset.

The price of the asset changes and volatility

results.
•Assuming
  that the returns on successive days are
independent and have the same standard deviation, this
means that

σyr = σday

Or

σday =
ARE DAILY PERCENTAGE CHANGES IN
FINANCIAL VARIABLES NORMAL?
A common assumption is that market variables are normal
so that we can calculate a confidence interval from daily
volatilities, as indicated in Examples 1 and 2.

In practice, most financial variables are more likely to

experience big moves than the normal distribution would
suggest.

Table 10.1 shows the results of a test of normality using

daily movements in 12 different exchange rates over a 10-
year period.
The first step in the production of the table is to calculate
the standard deviation of daily percentage changes in each
exchange rate.

The next stage is to note how often the actual percentage

changes exceeded one standard deviation, two standard
deviations, and so on.

These numbers are then compared with the corresponding

numbers for the normal distribution.
Daily percentage changes exceed three standard
deviations on 1.34% of the days.

The normal model for returns predicts that this should

happen on only 0.27% of days.

Daily percentage changes exceed four, five, and six

standard deviations on 0.29%, 0.08%, and 0.03% of days,
respectively.

The table, therefore, provides evidence to support the

existence of the fact that the probability distributions of
changes in exchange rates have heavier tails than the
normal distribution.
Figure 10.2 compares a typical heavy tailed distribution
(such as the one for foreign exchange) with a normal
distribution that has the same mean and standard deviation.

Kurtosis measures the size of a distribution’s tails.

A leptokurtic distribution has heavier tails than the normal

distribution.

A platykurtic distribution has less heavy tails than the

normal distribution.

A distribution with the same sized tails as the normal

distribution is mesokurtic.
The heavy-tailed distribution is more
peaked than the normal distribution.

Which tailed distribution tends to have

very large values with many outliers
(very high values)?
A heavy tailed distribution tends to
have very large values with many
outliers (very high values).

The heavier the tail, the larger the

probability that you’ll get one or more
very large values in a sample.
MONITORING DAILY VOLATILITY
•Define
  σn as the volatility per day of a market variable on day
n, as estimated at the end of day n − 1.

The variance rate, which as mentioned earlier is defined as

the square of the volatility is .

Suppose that the value of the market variable at the end of

day i is Si.

Define ui as the continuously compounded return during day i

(between the end of day i − 1 and the end of day i ) so that
•One
  approach to estimating n is to set it equal to the
standard deviation of the ui’s. With the most recent m
observations on the ui in conjunction with the usual formula
for standard deviation, this approach gives:

Where is the mean of the ui’s:

EXAMPLE
Table 10.3 shows a possible sequence of stock prices.
Suppose that we are interested in estimating the volatility
for day 21 using 20 observations on the ui so that n = 21
and m = 20.

In this case, find the volatility!

 Closing Stock
Price (dollars)
20
20.1
19.9
20
20.5
20.25
Table 10.3. 20.9
Data for 20.9
20.9
Computation 20.6
20.5
of Volatility 21
21.1
20.7
20.5
20.7
20.9
20.4
20.5
20.6
20.3
•In  this case,

x 0.01489

So that = 0.00074.
• 

x 0.004229587 = 0.00022261
• 
So, the estimate of the standard
deviation of the daily return is:
= 0.0149.
 ui )2
0.00499 0.00425 1.80625E-05
-0.01 -0.01074 0.000115348
0.00501 0.00427 1.82329E-05
0.02469 0.02395 0.000573603
-0.01227 -0.01301 0.00016926
0.03159 0.03085 0.000951723
0 -0.00074 5.476E-07
0 -0.00074 5.476E-07
-0.01446 -0.0152 0.00023104
-0.00487 -0.00561 3.14721E-05
0.0241 0.02336 0.00054569
0.00475 0.00401 1.60801E-05
-0.01914 -0.01988 0.000395214
-0.00971 -0.01045 0.000109203
0.00971 0.00897 8.04609E-05
0.00962 0.00888 7.88544E-05
-0.02421 -0.02495 0.000622503
0.00489 0.00415 1.72225E-05
0.00487 0.00413 1.70569E-05
-0.01467 -0.01541 0.000237468
Sum 0.01489 9E-05 0.004229587
•For
  risk management purposes, the formula in equation:

is usually changed in a number of ways:

1. ui is defined as the percentage change in the market

variable between the end of day i−1 and the end of day i
so that:

This makes very little difference to the values of ui that are

computed.
•2.  is assumed to be zero. The justification for this is that
the expected change in a variable in one day is very small
when compared with the standard deviation of changes.

3. m−1 is replaced by m. This moves us from an unbiased

estimate of the volatility to a maximum likelihood estimate.

These three changes allow the formula for the variance

rate to be simplified to
EXAMPLE
• 

So,

= ? σn = ?
• 
= 0.00424/20 = 0.000214

and σn = 0.014618 or 1.46%.

There is only a little difference from the

result in previous example.
 “Optimism…”

Thank you fellas

God bless, Good Luck and with love,

Dr. Ika Pratiwi Simbolon