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Business Expert Press 978-1-63157-896-0 (2018) Expert Insights
1
www.businessexpertpress.com
A Brief Look at Volatility and Using Volatility for Value
performance payout. This article begins by underlying will have more variable prices
discussing basic market volatility and payout in the future and that there will be a far
performance based on basic assumptions wider range of outcomes when it comes to
using basic equations and graphs. It then predicting future prices.
moves to a discussion of the differences be- Volatility is not static; it changes through-
tween implied volatility and historical volatil- out time. Generally, there are two basic
ity. Since historical volatility is used as trend types of volatility used in managing risk
volatility, the article shows how to build a on a trading floor: historical and implied.
historical volatility model in Excel. Finally, Historical volatility helps illuminate the
the article ends with how to use Bloomberg volatility trend and is backward looking.
in regard to volatility and volatility calcula- Historical volatility is realized volatility.
tions. The article does assume some basic Realized volatility (statistical volatility) is
knowledge of Bloomberg and options. based on the underlyings closing prices
(for a period, such as a day, a week, etc.).
Volatility and Risk Given that historical volatility is often mean
In its simplest form, volatility is risk. Vol- reverting, it follows that historical volatility
atility is often portrayed as an annualized is trend volatility (Marshall, 2008).
number, meaning that if volatility were
9%, we would expect the price of the un-
derlying to move 9% over the next year, up
or down. If the price of the underlying was Implied volatility illustrates what the
$115.00 and volatility was 9%, we would market expects the volatility to be in the fu-
expect the underlying price of the instru- ture and is forward looking: it is a measure
ment to move in the range of $125.25 to of market expectations of volatility of the un-
$104.65 over the next year. See Figure 1. derlying. Implied volatility can be inferred
If volatility is low, then we expect a nar- from the option price based on the under-
rower distribution in regard to the price lying. For example, at-the-money (ATM)
changes of the underlying asset. A low volatility is inferred from the closest option
volatility allows for a narrower range of price based on the current underlying price.
prediction of the underlyings future per- Figure 2 attempts to illustrate the differ-
formance. A high volatility implies that the ences in implied volatility methodologies.
Figure 1: Using volatility to predict price changes over a one year period