Financial Models in Excel Lecture 7 Volatility Prediction

Literature: The exercise!

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Motivation
What are we looking for? {Excel-slide} Purpose of predicting volatility:

Stock pricing according to, e.g., CAPM Long horizon (yearly) Risk management, e.g., Value at Risk J.P. Morgan/Risk Metrics T M (weekly) Option pricing Exercise 6. (Daily to yearly)

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Approaches to Volatility Prediction

1) Case oriented predictions, (ex: likelihood of war) Forward looking Using past information informally Shaky (any?) theoretical foundation ...

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Approaches to Volatility Prediction (2)

2) Implied volatilities via option prices Forward looking Solid theoretical foundation Cannot be used to price options Depend on option pricing model

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Approaches to Volatility Prediction (3)

3) Time series statistics: Use historical information from the series itself. Solid theoretical foundation Very popular in nance Only backward looking In practice: Combination of 2) and 3) (Datastream)

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Exercise 7: Overview
7.1 Data is S&P 500 index 7.2 Moving average st. dev. or Historical volatility (Ex 6) 7.3 Measure of t introduced => Choice of horizon 7.4 Exponentially weighted Used by JP Morgans Risk-Metrics Estimation/calibration of free parameter 7.5 GARCH (widely recognized) More free parameters and Dynamic predictions 7.6 Maximum likelihood => Estimation and TEST

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Exercise 7.1: Data

Data

10 years of daily S&P 500 index values Download Turnover gures to remove dead observations: Holidays, post Sep. 11 etc. Use {Data | Sort }

2) t Our model: Rt N (R,

not important before Ex 7.6. (Max. likelihood) is constant, (often = 0!) vary over time: The topic of the exercise.

R
2 t

N (0, 2 ) We work with excess return rt = Rt R t

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Exercise 7.2: Historical volatility

Historical volatility / Moving average
2 t

(rti 0)2 = n i=1 1 n 2 r t i = n i=1 1 2 1 2 1 2 1 2 = r t 1 + r t 2 + r t 3 + + r t n n n n n

Often called equally weighted moving average Try 2 months, 1 month, 2 weeks, 1 week. (What do you expect?)

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Exercise 7.3: RMSE

Q: What is best: 1 month or 2 weeks? A: We need a measure of t! Root Mean Squared Error (RMSE), (RiskMetrics)
RM SE = 1 T
T 2 rt t=1 2 t 2

Intuition: Average distance between predicted and realized volatility Exercise: Calculate RM SE for the 4 horizons and compare

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Exercise 7.4: EWMA

Exponentially Weighted Moving Average (EWMA)

Motivation Used by JP Morgan/RiskMetrics for everything!

2 = (1 ) t i=1 2 2 1 2 2 + r t 3 + + r = (1 ) 0 rt t 2 1 2 i1 rt i

Weights sum to one {blackboard} Different values, (RiskMetrics: 0.94) Cut-off problems => Correction methods

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Exercise 7.4 (2)

Very nice updating formula:
2 2 2 + = (1 )rt t t 1 1

Exercise:

Calculate EWMA for S&P 500 and compare Determine RMSE and compare Use Solver to nd optimal and compare with 0.94

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Exercise 7.4 (3)

How to predict volatility beyond t

Our information: {rt1 , rt2 , rt3 , , r1 }. standard dont work: rt missing

2 2 = (1 )r 2 + t t 1 t 1 2 2 + 2 = (1 ) r t t t +1

2 2 is t Solution: Best guess on rt 2 2 = 2 + 2 t t t t +1 = (1 )

And so on:

2 2 = t t+1 +2

Constant volatility predictions, no dynamics

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Exercise 7.4 (4)

Remember:
V ar(rweekly ) = V ar(r1 ) + V ar(r2 ) + + V ar(r5 ) = 5V ar(rdaily )

If constant variance

Fits EWMA predictions

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Exercise 7.5: ARCH and GARCH

Autoregressive Conditional Heteroscedasticity ARCH(n):
2 2 2 2 t = 1 rt + r + + r 2 n 1 t 2 t n

All s are free

Special cases: Historical vol. and EWMA Too hard to estimate (Robert Engle awarded Nobel price this month)

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Exercise 7.5: GARCH

Generalized ARCH: GARCH(n,q)
2 2 2 2 t = 1 rt + r + + r 2 t 2 n t n 1 2 2 2 + + + +1 t q 2 t q t 2 1

Not a generalization from a theoretical point of view More parameters!, but ... In practice GARCH(1,1) is enough: 2 2 = r2 + t 1 t 1 1 t 1 Two parameters only. Determine with RMSE

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Exercise 7.5: GARCH, (2)

Special case of GARCH(1,1)

Impose sum-to-one restriction:

1 = 1 1
2 2 2 + = (1 1 )rt t 1 t 1 1

Which is EWMA (and Historical volatility)

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Exercise 7.5: GARCH, (3)

Generalization of GARCH(1,1):

Add long term level of 2 : V Motivation {Blackboard}

2 2 2 + = V + 1 rt t 1 t 1 1

Consider + 1 + 1 = 1 (interpretation) Sum-to-one good for the Solver during estimation

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Exercise 7.6: Maximum likelihood

Motivation: RMSE is not the way to proceed

We need statistical tests of, e.g. Sum-to-one restriction =0

Maximum likelihood idea: What is likelihood of data given our model:

2 ) plus volatility model Our model: rt N (0, t

Density plot on blackboard Estimation of parameters maximizes likelihood/density

Maximum likelihood is crown jewel of statistics

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Exercise 7.6: Maximum likelihood (2)

Likelihood of individual rt in Excel:
L(rt )

= NORMDIST(rt ,0, t , F ALSE )

Note L(rt ) depend on , , and via t

Likelihood of all data:

L(r ) = L(r1 ) L(r2 ) L(r3 ) L(rT )

Numerical problems => Log-likelihood: (r) = ln(L(r))

(r ) = (r1 ) + (r2 ) + (r3 ) + + (rT )

Maximizing (r) or L(r) gives the same parameters

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Exercise 7.6: Maximum likelihood (3)

How to test a restriction (say + 1 + 1 = 1): 1 Estimate parameters without restrictions => Unrestricted loglikelihood value (r)U 2 Estimate parameters with restriction imposed => Restricted loglikelihood value (r)R 3 Two times the difference is 2 distributed => 2(U R ) 2 (n) where n is number of restrictions (here n = 1) 4 If 2(U R ) > 3.84 we reject restriction where 3.84 is 5% level {Blackboard} We can test e.g. = 0 exactly the same way.

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Literature
Exercise 13 pages Optional:

Alexanders Market models: The place to start... Hulls option book: Quick and precise introduction

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