Volatility

Chapter 8

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 1
 Definition of Volatility
⚫ Suppose that Si is the value of a variable on
day i. The volatility per day is the standard
deviation of ln(Si /Si-1)
⚫ Normally days when markets are closed are
ignored in volatility calculations (see Business
Snapshot 8.1)
⚫ The volatility per year is 252 times the daily
volatility
⚫ Variance rate is the square of volatility

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 2
 Implied Volatilities
⚫ Of the variables needed to price an option
the one that cannot be observed directly is
volatility
⚫ We can therefore imply volatilities from
market prices and vice versa

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 3
VIX Index: A Measure of the Implied
Volatility of the S&P 500 (Figure 8.1, page
167)
90

80

70

60

50

40

30

20

10

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 4
 Are Daily Changes in Exchange Rates
Normally Distributed? (Table 8.1)

Real World (%) Normal Model (%)

>1 SD 23.32 31.73
>2SD 4.67 4.55
>3SD 1.30 0.27
>4SD 0.49 0.01
>5SD 0.24 0.00
>6SD 0.13 0.00

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 5
 Heavy Tails
⚫ Daily exchange rate changes are not normally
distributed
⚫ The distribution has heavier tails than the normal
distribution
⚫ It is more peaked than the normal distribution
⚫ This means that small changes and large
changes are more likely than the normal
distribution would suggest
⚫ Many market variables have this property,
known as excess kurtosis
Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 6
 Normal and Heavy-Tailed
Distribution

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 7
 Alternatives to Normal Distributions:
The Power Law (See page 170-172)

Prob(v > x) = Kx-a

This seems to fit the behavior of the

returns on many market variables better
than the normal distribution

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 8
 Log-Log Test for Exchange Rate Data (v
is number of standard deviations which
the exchange rate moves)
0
0 0.5 1 1.5 2
-1
ln(x)
-2
ln(Prob(v>x)

-3

-4

-5

-6

-7

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 9
Standard Approach to Estimating
Volatility
⚫ Define sn as the volatility per day between
day n−1 and day n, as estimated at end of
day n−1
⚫ Define Si as the value of market variable at
end of day i
⚫ Define ui= ln(Si/Si-1)
m
1
sn =  − u)
2 2
(u n −i
m−1 i =1

m
1
u =
m
 u n −i
i =1

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 10
 Simplifications Usually Made in
Risk Management
⚫ Define ui as (Si−Si−1)/Si−1
⚫ Assume that the mean value of ui is zero
⚫ Replace m−1 by m

This gives
1

m
sn =
2 2
un − i
i =1
m

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 11
 Weighting Scheme
Instead of assigning equal weights to the
observations we can set


m
sn = a i un −i
2 2
i =1

where
m

a i
=1
i =1

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 12
 ARCH(m) Model
In an ARCH(m) model we also assign
some weight to the long-run variance rate,
VL:
m
s n = V L +  a i u n −i
2 2
i =1

where
m

+ a i
=1
i =1

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 13
 EWMA Model (page 175-177)

⚫ In an exponentially weighted moving

average model, the weights assigned to
the u2 decline exponentially as we move
back through time
⚫ This leads to

sn = s + (1 −  ) u n − 1
2 2 2
n −1

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 14
 Attractions of EWMA
⚫ Relatively little data needs to be stored
⚫ We need only remember the current
estimate of the variance rate and the most
recent observation on the market variable
⚫ Tracks volatility changes
⚫  = 0.94 has been found to be a good
choice across a wide range of market
variables

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 15
 GARCH (1,1), page 177-179
In GARCH (1,1) we assign some weight to
the long-run average variance rate

s =  V L + a u n −1 + b s n −1
2 2 2
n

Since weights must sum to 1

 + a + b =1

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 16
 GARCH (1,1) continued
Setting w = VL the GARCH (1,1) model is
s = w + a u n −1 + b s n −1
2 2 2
n

and

w
VL =
1− a − b

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 17
 Example
⚫ Suppose

s = 0 . 0 0 0 0 0 2 + 0 .1 3 u n − 1 + 0 .8 6 s
2 2 2
n n −1

⚫ The long-run variance rate is 0.0002 so

that the long-run volatility per day is 1.4%

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 18
 Example continued
⚫ Suppose that the current estimate of the
volatility is 1.6% per day and the most
recent percentage change in the market
variable is 1%.
⚫ The new variance rate is
0 . 0 0 0 0 0 2 + 0 .1 3  0 . 0 0 0 1 + 0 . 8 6  0 . 0 0 0 2 5 6 = 0 . 0 0 0 2 3 3 3 6

The new volatility is 1.53% per day

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 19
 GARCH (p,q)

p q

sn = w + a u n −i + b s n− j
2 2 2
i j
i =1 j =1

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 20
 Other Models
⚫ Many other GARCH models have been
proposed
⚫ For example, we can design a GARCH
models so that the weight given to ui2
depends on whether ui is positive or
negative

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 21
 Maximum Likelihood Methods

⚫ In maximum likelihood methods we

choose parameters that maximize the
likelihood of the observations occurring

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 22
 A Simple Example
⚫ We observe that a certain event happens
one time in ten trials. What is our estimate
of the proportion of the time, p, that it
happens?
⚫ The probability of the outcome is
p (1 − p )
9

⚫ We maximize this to obtain a maximum

likelihood estimate: p = 0.1
Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 23
 Estimating a Constant Variance
Estimate the variance of observations from
a normal distribution with mean zero
n
 1  − ui
2

Maximize :  exp 



i =1  2v  2v 

 ui 
n 2

Same as maximizing :  − ln( v) − v 

i =1  
n
1
v=  ui
2
Maximum value when
n i =1

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 24
 Application to EWMA and
GARCH
We choose parameters that maximize

 ui 
m 2
1
 exp  −



i =1 2vi  2vi 

or

 ui 
m 2

 − ln( vi ) − v 
i =1  i 

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 25
 S&P 500 Excel Application
⚫ Start with trial values of parameters ( for
EWMA and w, a, and b for GARCH(1,1)
⚫ Update variances
⚫ Calculate  m
u 
2

  − ln( v ) −
i
i 
i =1  vi 

⚫ Use solver to search for values of parameters

that maximize this objective function
⚫ For efficient operation of Solver: set up
spreadsheet so that ensure that search is over
parameters that are of same order of
magnitude and test alternative starting
conditions
Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 26
 S&P 500 Excel Application (Table 8.4)

Date Day Si ui=(Si−Si-1)/Si-1 vi =si2 −ln(vi ) −ui2 /vi

02-Feb-2017 1 2280.85
03-Feb-2017 2 2297.42 0.007265
06-Feb-2017 3 2292.56 −0.002115 0.000053 9.7646
07-Feb-2017 4 2293.08 0.000227 0.000045 10.0057
……. ….. ……. ……….. …………. …………
01-Feb-2022 1259 4546.56 0.006863 0.000233 8.1628
Total 10,764.3624

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 27
 The S&P 500 (Figure 8.4)
5,000.00

4,000.00

3,000.00

2,000.00

1,000.00

0.00

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 28
 The GARCH Estimate of
Volatility of the S&P 500 (Figure 8.5)
9.00%

8.00%

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 29
 Variance Targeting
⚫ One way of implementing GARCH(1,1)
that increases stability is by using variance
targeting
⚫ The long-run average variance equal to
the sample variance
⚫ Only two other parameters then have to be
estimated

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 30
 How Good is the Model?

⚫ The Ljung-Box statistic tests for

autocorrelation
⚫ We compare the autocorrelation of the
ui2 with the autocorrelation of the
ui2/si2

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 31
 Forecasting Future Volatility
(equation 8.14)

A few lines of algebra shows that

E[s ] = VL + (a + b) (s − VL )
2
n+k
k 2
n

The variance rate for an option expiring on

day m is m −1

 E s 
1 2
n+k
m k =0

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 32
 Forecasting Future Volatility
continued (equation 8.15)

Define
1
a = ln
a +b

The estimated volatility per annum for an option lasting T days is

 1 − e− aT 
252  VL + V (0) − VL  
 aT 

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 33
 S&P Example (Table 8.6)
a = 0.02698

Option Life 10 30 50 100 500

(days)
Est. Volatility 26.62 25.20 24.13 22.45 19.98
(% per annum)

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 34
 Volatility Term Structures
⚫ GARCH (1,1) suggests that, when calculating vega,
we should shift the long maturity volatilities less than
the short maturity volatilities
⚫ When instantaneous volatility changes by Ds(0),
volatility for T-day option changes by
1 − e − aT s(0)
Ds(0)
aT s(T )

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 35
 Results for S&P 500 (Table 8.7)
When instantaneous volatility changes by
1%

Option Life 10 30 50 100 500

(days)
Volatility 0.91 0.75 0.63 0.42 0.10
increase (%)

Risk Management and Financial Institutions 6e, Chapter 8, Copyright © John C. Hull 2023 36