Evaluating The Volatility Of A Stock Market Return Finance Essay

Introduction

The importance of volatility is good known and widely acclaimed in the country of fiscal sector. Portfolio Managers, corporate Treasures and other finance executives rely on the volatility trends of the stocks to take the investing determination. Volatility in a manner is a arrow to the hazard involved with a peculiar plus. As Fontanills et Al. ( 2003 ) , describes, Price, clip and volatility are the three pillars of any successful trading. Hence a volatility of any stock chiefly reflects the basicss, information, and market outlooks of a peculiar stock. Hence volatility becomes one of the nog to quantify the hazard involved with the stocks and portfolio investings.

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In layperson ‘s term, a volatility defines how much a stock is expected to see a drastic addition and lessening in monetary values and volumes in a peculiar period of clip. The more the volatility of the stock, the more is the hazard associated with the investing in that stock. ( Dwyer, 1998 ) .

Investing activity requires that the investors, agents and other investing agents and portfolio directors do take into history the grade of the stock volatility associated with any stock prior to doing an investing in that peculiar stock. Apart from this, investors are besides peculiarly interested in the factors which have made an impact on the volatility of the stock. These factors are so utilized in foretelling the future tendency of the stock and therefore analysing the hazard involved with the investing in that peculiar stock. Hence the thought of understanding the volatility of the stocks is to pull off the investing so that the returns are maximized and hazards of losingss are at lower limit. ( Gregoriou, 2009 ) .

The purpose of this research paper is to discourse about the function of volatility as one of the quantitative hazard direction tools. We shall research the factors impacting the volatility and other implicit in constructs involved with the volatility. We shall so exemplify the methods of ciphering volatility of the portfolio of stocks. We shall besides pattern a portfolio of stocks and shall exemplify the constructs of volatility on that modeled portfolio of stocks. With this Aim of our research undertaking we shall deduce the undermentioned aims at the decision of this research:

Understanding Volatility as one of the hazard direction tools in the stock market.

Understanding how to pattern the volatility and quantifying the hazard involved in the stock.

Modeling a sample portfolio to use the rules and basicss explored and deduce the volatility of the modeled portfolio through quantitative methods.

The remainder of the paper is structured into the undermentioned chapters:

Literature Reappraisal: In this chapter, we shall explicate how this research survey is related with the old literatures.

Data and Methodology: In this subdivision we shall depict the informations and the statistical and quantitative methods which would be applied to pattern our portfolio for the rating of volatility.

Analysis and Consequences: Here we shall critically analyse the consequences obtained and the decision deduced from the consequences of our theoretical account.

Decision: In this chapter we shall sum up our undertaking and shall infer at the decision that how our Purposes and Aims defined at the start of the paper has been achieved and how they are aligned with the literature reappraisal explained. We shall besides sum up the route map of the hereafter work which can be done to further heighten the undertaking.

Literature Review

Volatility is one of the of import facets of fiscal market in general and hazard direction in peculiar and provides an of import input for portfolio direction, market ordinance and option pricing ( Poon and Granger, 2003 ) . There are legion surveies which highlights the importance of market volatility in fiscal direction. These surveies which includes Harvey and Bekaert ( 1997 ) , Kim and Sehgal ( 1999 ) and Dwyer and Hafer ( 1998 ) frequently associate volatility as a negative facet to the stock market and stand for it with the hazard involved in the investing. Other surveies like Lee et Al. ( 1991 ) remark that volatility is frequently desirable with assorted investing schemes as it gives an chance for an investor to come in the stock when the volatility of the stock is at its low and book the net incomes when the volatility is at its extremum.

As Dwyer et Al. ( 1998 ) remarks, there are figure of factors that can impact volatility. One of the factors is the stableness of the implicit in assets of a peculiar stock on which the populace or the investors has assurance. If the public assurance on a peculiar stock lessenings, there are high opportunities that the stock might witness a steep alteration in the monetary value of the stock. The deficiency of assurance in a stock may be due to figure of factors like authorities policy straight impacting the concern of that stock, market conditions which straight affects the profitableness of the company and therefore the investors losing assurance in the stock of that company and so on. On the other manus, the intelligence like the company planning to spread out which expects to increase the profitableness of the company or proclamation of any amalgamation and acquisitions which shall increase and spread out the concern of the company will all of a sudden convey involvement and assurance in the stock of that company as a consequence of which the stock of the company shall witness a positive volatility in the stock.

Dwyer et Al. ( 1998 ) observes that bargainers need to be cognizant of the grade of volatility associated with the stock. When this is applied to the pricing theoretical accounts such as Black-sholes, gives a anticipation of the tendency the stock is likely to follow and therefore can give the investor an penetration and assistance in determination devising to whether to put or go out from the stock.

Volatility quantifies the hazard of a fiscal instrument and is referred to the standard divergence of the continuously compounded returns of the fiscal instrument within the specified clip period ( Campbell et al. 1997 ) .

In this paper, we shall mention to two types of volatility viz, Implied Volatility and Historical volatility.

Historical Volatility is the statistical computation which gives an indicant to the bargainers how rapid has been the motion of the stock in a given period of clip. The most common statistical method to cipher historical volatility is the Standard Deviation or Sigma ( I? ) . Since Standard Deviation is the step of scattering of the informations from its norm or mean, therefore the divergence derived is frequently referred to as the volatility of the stock. The greater the scattering from its norm, the more volatile the stock would be. ( Fontanills et al. , 2003 ) .

Frequently a high volatility stock would depict the undermentioned behaviour diagrammatically

The figure below describes the behaviour of a stock with low volatility.

From the above figures we can infer that a stock with a high volatility frequently has unpredictable behaviour and hence gives an chance to the investor to do good net incomes but at a hazard of come ining into losingss with equal chance unless the factors doing the stock volatile is non surveies decently. Contrary to this a stock with low volatility has more or less predictable behaviour and hence investing in these stock would be safer but with low returns.

Implied Volatility is the analysts view or anticipation that what would be the volatility of the stock in the close hereafter. This is derived from the pricing theoretical account such as Black-Sholes or GARCH ( 1,1 ) . The input to the pricing theoretical account is the current theoretical value of the stock which when applied to the pricing theoretical account, gives the markets position of how volatile a stock would be in the hereafter. ( Li, 2002 ) .

Data and Methodology

In this chapter we shall use the statistical method to quantify the volatility of the portfolio of stocks. First, we shall explicate the statistical methods involved in ciphering the volatility of the stocks utilizing Historical Method and will so pattern a sample portfolio which shall take the 2 twelvemonth return of UK stock exchange ( FTSE ) whose historical information shall be derived from the website hypertext transfer protocol: //uk.finance.yahoo.com/ .

Estimating stock Volatility from Historical Monetary values

Suppose that we have a historical information of stocks which would be typically in the period for a hebdomad, month or over old ages. We shall wish to gauge the volatility or standard divergence of the stock returns for this period of clip.

Some Definitions:

n+1 Number of Observations

St Stock monetary value at the terminal of the tth interval where, t = 0, 1, 2 aˆ¦ N.

With this definition, we shall now specify the periodic rate of return of the stock.

The periodic rate of return of the stock can be defined as:

ut = ln ( ) aˆ¦Equation 1

This attack of ciphering periodic rate of returns is really gauging a Geometric Mean return for a clip series of return figures of a stock.

Now when we have computed the Ut, which is the periodic rate of return of the stock, we shall now cipher the standard divergence or Volatility of Ut ‘s for the give clip period by the undermentioned equation

Volatility or SD = … Equation 2

Where, Ut is the periodic rate of return and Um is the mean or mean of all the Ut ‘s calculated.

In the equation 2, supra, we have defined Volatility as the Standard Deviation over the period of clip.

Having discussed the volatility, we shall present another term Variance which shall give another definition to the volatility.

The term in the equation 2 above is besides known as day-to-day discrepancy of the stock. Hence the whole term inside the square root in equation 2, is the norm of the day-to-day discrepancy, which in general is known as Variance ( I?2 ) .

Therefore, we can now specify the Volatility as the square root of the Variance.

i.e. Volatility ( I? ) =

or Variance = I?2

Finally, one time we get the standard divergence of all the periodic rates of return, derived in equation 2, we shall specify the Average volatility or the annualized appraisal of the standard divergence by the expression

I? = aˆ¦Equation 3

Here, SD is the standard divergence calculated in the equation 2 above and T is the Time period for which the criterion divergence is calculated.

We shall explicate the constructs derived in this equation with the aid of some statistical informations to do the things more clear.

We shall be ciphering the day-to-day volatility of the FTSE 100 Index for the last 15 yearss to do the constructs of the volatility clear. Subsequently as an exercising, we shall cipher the volatility for the full two twelvemonth period to deduce our decision of the research.

In the tabular array spring below, we shall foremost take the historic information of the last 15 yearss of FTSE100 index, and shall cipher discrepancy

The tabular array below shows the computation we have done to deduce the volatility of the FTSE100 index for the last 15 yearss.

The day-to-day return Ut has been calculated utilizing equation 1.

Um is the mean or mean of the day-to-day return. Variance is so calculated as the norm of the day-to-day discrepancy.

The concluding volatility is so derived as the Square root of the discrepancy.

Analysis of the consequence

With the statistical constructs illustrated in the old chapter, we have calculated the volatility of the FTSE 100 Stock Exchange shutting Ratess between the period of 01-04-08 to 01-07-10 which is around 575 on the job yearss.

The sample illustration illustrated in the old subdivision has been enhanced for this clip period to cipher the volatility.

Before analysing our consequence, we shall foremost exemplify diagrammatically, the tendency followed by FTSE 100 Closing Rates for this period. This can be found in the Excel Sheet prepared for the intent of ciphering Volatility.

If we analyze the above graph for this clip period, we can see that the market has been extremely volatile during the first half of this clip period, the market declined and reached its lowest shutting point from its extremum of around 6500 points. After this, in the 2nd half of this clip period, the market has shown recovery which has been slow as compared to the market ruin during the first half. The market is yet to retrieve and make its highest shutting point registered.

The above graph gives a just thought about the construct of volatility which was established in the literature reappraisal subdivision. We can detect that this information is important in assorted facets sing the behaviour of the market.

As an analyst or bargainer, if one analyzes the above graph to look into the factors for doing the market so volatile, one can notice that the ground for crisp diminution in the market in the first half which was the twelvemonth from late 2008 – mid 2009, during which the whole universe got into the clasp of fiscal crisis and recession. The recovery suggests that the recession has been on the withdrawing way but the market is yet to retrieve decently to the degrees at the start of 2008 Fiscal Year and therefore the investor can happen a really good ground to put into the market as the recovery would take to the rise in the stock monetary values and overall market scenario might go better in approaching months.

However, we can detect that the volatility does non give the complete image of the hazard associated with the stock market. If one asks that what are the opportunities that the investing might give a loss, so this can non be derived from the volatility. This can be answered by assorted other hazard direction tools like Value at Risk ( VaR ) or Expected Shortfall ( ES ) which would be more utile to quantify the hazard.

However, Volatility gives a just thought of the behaviour of the market or stock and is the first degree of observation which any investing director would take before doing any investings.

Hypothesis Testing

Having established the constructs and basicss of volatility for the FTSE100 shutting rate, we shall now make a arrested development and hypothesis proving for FTSE100 against FTSE MID 250 Historical monetary value for the same continuance.

Measuring Correlation

For the same historical clip period, we measured the correlativity between the returns of FTSE 100 and FTSE MID 250. We were interested in mensurating the correlativity because we attributed the high volatility of FTSE 100 to the recession in which the universe market was gripped in and hence we wanted to mensurate how much correlativity make our hypothesis for FTSE 100 tantrums in the instance of FTSE MID 250.

Following is the consequence of correlativity for the two indices.

Correlation

A

Daily Rate of return

( Um ) FTSE250

Daily Rate of return

( Um ) FTSE100

Daily Rate of return

( Um ) FTSE250

1

A

Daily Rate of return

( Um ) FTSE100

0.863576074

1

The grade of correlativity measures how the much strongly the two variables are correlated to each other. It is frequently defined by the symbol “ R ” which has the undermentioned significance:

When ‘r ‘ = +1, i?? Perfect correlativity

When ‘r ‘ = 0, i?? No Correlation

When ‘r ‘ = -1, i?? Perfect negative correlativity

From the tabular array, we can see that day-to-day return of FTSE250 Index and FTSE 100 Index have perfect co-relation as the value 0.86 is ~1. Hence our hypothesis that the recession of universe economic system and its subsequent recovery was closely followed by both the indexes.

We shall now execute the arrested development for these two returns to farther set up our hypothesis.

We shall utilize Multiple Variables Regression Model to execute our arrested development for FTSE 250 day-to-day returns and FTSE 100 Daily return.

The equation for the same would be

Y = I± + I?X + Iµ aˆ¦Equation 4

Here, FTSE250 is the dependent variable Yttrium, X is the variable for FTSE 100 Daily return and Iµ is the error term added to do the theoretical account more probabilistic and deterministic. I± is the intercept of the arrested development line and I? is the incline of the arrested development line.

Therefore the reading of the above equation is as follows which is derived from our arrested development proving in the excel sheet.

A

Coefficients

Standard Error

Intercept

6.01441E-05

0.000360121

X Variable 1

0.797981345

0.019566784

Therefore here, 6.01441E-05 is the I± in our equation 4.

0.797981345 is the I? in the equation 4.

Therefore the value of FTSE250 alterations depending on the value of FTSE100 value multiplied and added by this coefficient along with taking into consideration, the standard mistake.

Besides, in the Regression statistics derived from our arrested development testing,

Arrested development Statisticss

Multiple R

0.863576074

R Square

0.745763635

Adjusted R Square

0.745315246

Standard Error

0.008588695

Observations

569

We can observer from the above tabular array that out of 569 Observations, 74.57 % times, a alteration in the value of FTSE100 besides changed the value of FTSE250. This is derived from the value of R Square whose value is 0.7457 or 74.57 % .

Null Hypothesis Testing

The arrested development proving done was with the assurance degree of 95 % . This method is normally expressed in footings of a chance i.e. P-value that helps in quantifying the strength of the grounds against the void hypothesis in favour of the option. The other hypothesis i.e. alternate hypothesis is what we expect to be true if the void hypothesis is false. We can non turn out that the alternate hypothesis is true but we may be able to depict that the option is much more believable than the void hypothesis given the information.

H0: = 0, there is no relationship between Dependant and Independent Variable.

H1: a‰ 0, there is relationship between Dependant and Independent Variable.

A

Coefficients

Standard Error

T Stat

P-value

Intercept

6.01441E-05

0.000360121

0.167011

0.867421

X Variable 1

0.797981345

0.019566784

40.78245

9.4E-171

We can see that the p-value of 0.867 is much higher which means that the option is much more higher than the void hypothesis.

Hence we can reason that the both the index are extremely correlated and have important relationship between Dependant variable and the independent variable.

Decision

At the start of this research paper, we had set our Purpose of this undertaking to set up and depict the function of Volatility as one of the hazard direction tool. With our research and the sample illustration of the shutting rates of the FTSE100 exchange, we have analyzed how Volatility can be used for analysing the market behaviour and its tendencies so that investing and fiscal experts can take a call on doing investing determinations.

We besides discussed about the quantitative attack to cipher the volatility and applied the logic and the constructs in deducing the volatility in our illustration of FTSE100 shutting rates for the last 575 yearss.

In the terminal we discussed that how volatility can be used to gauze the market behaviour based on our consequences and computations done to cipher the volatility.

However, we have besides observed that, volatility entirely can non be the lone tool to quantify the hazard involved in the stock market investings. We need assorted other quantitative methods like Value at Risk ( VaR ) and Expected Shortfall ( ES ) to hold more confident investing determinations. The research can be farther extended to research these hazard direction tools and compare them.

The Volatility method suggested in this paper is based on the historical informations. We can farther heighten this research to cipher implied volatility by utilizing GARCH ( 1,1 ) and Black-Sholes Method which work on imitating the hereafter tendency based on the current consequences. Hence the quantitative consequences obtained in this research can be used to pattern the hereafter tendency which the market would follow and would give a better penetration of the investing determination.

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