Volatility

• Volatility is a huge issue in risk management.

• 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 the key parameter in modeling market risk.
• Volatility is essentially the standard deviation of daily portfolio
returns.
• Volatility = Si − Si−1 / Si−1
• Some investors enjoy the stock market volatility but some get
killed by the same volatility.
• Different people view the same thing differently.
• But all of them seek one thing above all else: Clarity.

• EXAMPLE : 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
• Volatility reflects the extent to which the value of our investment
may be subject to the mood of the market over a given period
of time.
• In other words, volatility refers to the amount of uncertainty or
risk about the size of changes in a security’s value.
• Commonly, it is observed that the higher the volatility, the riskier
the security.
• A volatility index tells us about the market expectations over the
short term, usually a month.
• It tries to capture the sentiments of the market- whether the
market is in a complacent or anxious mood.
• Volatility is what makes our short-term investments looks more
dangerous than our long-term investments.
• Some investors feel that surviving short-term market
volatility is more challenging than surviving in the long-
run.

• Business Days vs. Calendar Days One issue is whether time

should be measured in calendar days or business days. As
shown in Business Snapshot 10.1, research shows that volatility
is much higher on business days than on non-business days.
As a result, analysts tend to ignore weekends and holidays
when calculating and using volatilities. The usual assumption is
that there are 252 days per year
 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. However, this view of what causes volatility is not
supported by research. With several years of daily data on an
asset price, researchers can calculate:

• 1. The variance of the asset’s returns between the close of

trading on one day and the close of trading on the next day
when there are no intervening non trading days.
• 2. The variance of the asset’s return between the close of
trading on Friday and the close of trading on Monday
• The second is the variance of returns over a three-day period. The first is a
variance over a one-day period. We might reasonably expect the second
variance to be three times as great as the first variance. Fama (1965),
French (1980), and French and Roll (1986) show that this is not the case.
For the assets considered, the three research studies estimate the second
variance to be 22%, 19%, and 10.7% higher than the first variance,
respectively.
• At this stage you might be tempted to argue that these results are
explained by more news reaching the market when the market is open for
trading. But research by Roll (1984) does not support this explanation. Roll
looked at the prices of orange juice futures. By far the most important news
for orange juice futures is news about the weather, and this is equally likely
to arrive at any time. When Roll compared the two variances for orange
juice futures, he found that the second (Friday-to-Monday) variance is only
1.54 times the first (one-day) variance. The only reasonable conclusion
from all this is that volatility is, to a large extent, caused by trading itself.
(Traders usually have no difficulty accepting this conclusion!
• Volatile markets can turn upside down in very
quick time.
• In fact, John Maynard Keynes himself once said
that markets can remain irrational longer than you
can remain solvent.
• So every now and then, we may see investors
getting caught on the wrong side of market
irrationality.
• A volatility index captures implied volatility in market.
• Implied volatility draws its conclusions from the present
pricing of options and not from historic volatility figures.
• It is expressed in terms of a percentage like 20%, 30%,
etc. In a range-bound market, where prices are moving
gradually, the volatility index remains low.
• It is believed that when the volatility index is less than
20%, the market is in complacent mood and is not
expecting any catastrophe.
• A low volatility index is therefore, associated with
price rise.
• But when the volatility index is greater than 30%,
then the market is in the fear zone.
• A high volatility index is associated with a fall in
market prices.
• In this manner, a volatility index help investors
gauge the mood of the market.
• The Chicago Board of Options Exchange (Cboe)introduced
the first volatility index for the US markets in 1993.
• Cboe Vix uses the Standard and Poor’s 500 Index Options for
calculating implied volatility, which is reflected by the changes in
pricing of options.
• The volatility index generally calculates the percentage of
volatility by using a detailed computational methodology, which
relies on the best bid and offer price of particular index of call
and put options.
• Other than gauging the mood of the stock market, a volatility
index can also be used to design derivative products in which
the volatility index is used as an underlying asset.
• Investors who are averse to volatility can hedge their portfolio by
purchasing derivative products based on the volatility index.
• An investor with a good appetite for a volatility can take the risk by
selling the same derivative products.
• All in all, a volatile index provides a new game of hedging and
trading for market participants.
• But how is hedging through volatility index derivatives different
from hedging through single stock or index derivatives?
• In fact, hedging through single stock or index derivatives is like
purchasing a comprehensive insurance which covers many risks
that you may not be even aware of.
• But a derivative product based on volatility index keeps its focus
narrow-it provides a hedge against only market volatility.
• So if the prices of your company’s shares are likely to fall due to
the poor quarterly results, then purchasing volatility index
derivatives may not protect you.
• The market may remain calm even though your own individual
portfolio may be performing badly.
• But if the prices of your stocks are likely to fall due to poor
marketing sentiments and not due to any company-specific
reasons, then a volatility index derivatives may be your right bet.