Standard deviation and volatility models
Types of volatility
- Price volatility: Volatility in price is caused by two main factors that lead to an increased swing in demand and supply. These include:
- Seasonality: For instance, beach resort prices will hike in summer when people want to spend more time on the beach. They drop in winter when people are not traveling to the beach. This is an example of changes in demand.
- Weather: For instance, the price of agricultural products depends on the supply. The increase in supply will depend on the atmospheric conditions being favorable to crops.
- Stock volatility: Some stock prices are highly volatile, and this unpredictability makes investing in stock a risky undertaking. Consequently, investors want a much higher return for the high uncertainty levels. Companies whose stocks are highly volatile need to grow profitably. They have to register a significant increase in earnings as well as in stock prices over time to avoid paying high dividends.
- Historical volatility: Just as the name hints, historical volatility is the measure of the level of volatility stock has recorded over the last year. If the price of the stock varied greatly in the past twelve months, it is more volatile, and hence riskier.
- Implied volatility: This describes the amount of volatility the options traders think a stock they are analyzing is going to have in the future. One can determine the implied volatility of a given stock by looking at how much the future prices of options vary. If the prices of options are starting to rise, this means that the implied volatility is increasing, everything else being equal.
The significance of volatility modeling
- Derivative pricing and hedging
- Risk management
- Market timing
- Market making
- Portfolio selection
- A risk manager will want to know the likelihood of his portfolio to decline in the future
- An options trader must know how much volatility to expect over the life of the contract
- A manager may need to sell a portfolio or a stock before it becomes too volatile
- Historical/sample volatility measuring
- Poisson jump-diffusion model
- Geometric Brownian motion model
- ARCH model
- GARCH model
- Stochastic volatility model
- Implied volatility from derivatives/options
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