Homework 1 - Single Asset Risk

September 28, 2013

Risk Modeling and R In this homework we will explore the topic of estimating volatility for a single asset. For these time series we will compare the three volatility estimators we discussed in class, the MA, the EMA and the ARCH. The real important question is how to compare the estimators. Consider our problem. We try to estimate t from observation up to time but not including time t. In essence, from statistics we know that rt /t has a variance of one. Therefore the better our estimator the better the normalized observation will have a variance of one. As such, 2 we will measure how much the variance of rt / t is close to one. Lets make this denition accurate. Denote by t,m r t the estimated volatility using method m. You will then calculate zt,m = 2 and our criteria will be the model
t,m

1) . that minimizes We will use three time series in our exploration. I have uploaded two time series into the homework folder in the coursework. In addition, you should generate a third some series based on the following formula: rt N (0, 2 + sin(t/20)), i.e., the return at time t is normally distributed with zero mean and standard deviation of 2 + sin(t/20) and the length of the sequence should be 1000 observations. We will compare the following methods: 1. Moving average with a window length of 20. 2. EMA where you will choose the best .
2 2 = + rt 3. ARCH model of order 4. That is, t 1 .

T 2 t=100 (zt,m

For each of the series your R script should: 1) Plot the original time series. 2) Plot zt,m for all the methods. 3) Comment on each of the methods, what can you observe. 4) For the third time series, you should also include the Oracle method, i.e., the one that knows the volatility accurately (note since you generated the sequence you know it.)