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Hull OFOD11 e Solutions CH 23
Hull OFOD11 e Solutions CH 23
Practice Questions
23.1
Define u i as (Si Si 1 ) Si 1 , where S i is value of a market variable on day i . In the EWMA
model, the variance rate of the market variable (i.e., the square of its volatility) calculated for
day n is a weighted average of the un2i ’s ( i 1 2 3…). For some constant ( 0 1 ), the
weight given to un2i 1 is times the weight given to un2i . The volatility estimated for day
n , n , is related to the volatility estimated for day n 1 , n1 , by
n2 n21 (1 )un21
This formula shows that the EWMA model has one very attractive property. To calculate the
volatility estimate for day n , it is sufficient to know the volatility estimate for day n 1 and
un 1 .
23.2
The EWMA model produces a forecast of the daily variance rate for day n which is a
weighted average of (i) the forecast for day n 1 , and (ii) the square of the proportional
change on day n 1 . The GARCH (1,1) model produces a forecast of the daily variance for
day n which is a weighted average of (i) the forecast for day n 1 , (ii) the square of the
proportional change on day n 1 , and (iii) a long run average variance rate. GARCH (1,1)
adapts the EWMA model by giving some weight to a long run average variance rate.
Whereas the EWMA has no mean reversion, GARCH (1,1) is consistent with a mean-
reverting variance rate model.
23.3
In this case, n1 0015 and un 05 30 001667 , so that equation (23.7) gives
n2 094 00152 006 0016672 00002281
The volatility estimate on day n is therefore 00002281 0015103 or 1.5103%.
23.4
Reducing from 0.95 to 0.85 means that more weight is put on recent observations of ui2
and less weight is given to older observations. Volatilities calculated with 085 will react
more quickly to new information and will “bounce around” much more than volatilities
calculated with 095 .
23.5
The volatility per day is 30 252 189% . There is a 99% chance that a normally
distributed variable will be within 2.57 standard deviations. We are therefore 99% confident
that the daily change will be less than 257 189 486% .
23.6
The weight given to the long-run average variance rate is 1 and the long-run average
variance rate is (1 ) . Increasing increases the long-run average variance rate;
increasing increases the weight given to the most recent data item, reduces the weight
given to the long-run average variance rate, and increases the level of the long-run average
variance rate. Increasing increases the weight given to the previous variance estimate,
reduces the weight given to the long-run average variance rate, and increases the level of the
long-run average variance rate.
23.7
The proportional daily change is 0005 15000 0003333 . The current daily variance
estimate is 00062 0000036 . The new daily variance estimate is
09 0000036 01 00033332 0000033511
The new volatility is the square root of this. It is 0.00579 or 0.579%.
23.8
With the usual notation un–1 = 20/3040 = 0.006579 so that the new variance is
so that n = 0.00983. The new volatility estimate is therefore 0.983% per day.
23.9
(a) The volatilities and correlation imply that the current estimate of the covariance is
025 0016 0025 00001.
(b) If the prices of the assets at close of trading are $20.5 and $40.5, the proportional
changes are 05 20 0025 and 05 40 00125 . The new covariance estimate is
095 00001 005 0025 00125 00001106
The new variance estimate for asset A is
095 00162 005 00252 000027445
so that the new volatility is 0.0166. The new variance estimate for asset B is
095 00252 005 001252 0000601562
so that the new volatility is 0.0245. The new correlation estimate is
00001106
0272
00166 00245
23.10
The long-run average variance rate is (1 ) or 0000004 003 00001333 . The
long-run average volatility is 00001333 or 1.155%. The equation describing the way the
variance rate reverts to its long-run average is equation (23.13)
E[ n2k ] VL ( )k ( n2 VL )
In this case,
E[ n2k ] 00001333 097k ( n2 00001333)
If the current volatility is 20% per year, n 02 252 00126 . The expected variance
rate in 20 days is
00001333 09720 (001262 00001333) 00001471
The expected volatility in 20 days is therefore 00001471 00121 or 1.21% per day.
23.11
Using the notation in the text u n1 001 and vn1 0012 and the most recent estimate of
the covariance between the asset returns is cov n1 001 0012 050 000006 . The
variable un1 1 30 003333 and the variable vn1 1 50 002 . The new estimate of the
covariance, cov n , is
0000001 004 003333 002 094 000006 00000841
The new estimate of the variance of the first asset, u n is
2
23.12
The FTSE expressed in dollars is XY where X is the FTSE expressed in sterling and Y is
the exchange rate (value of one pound in dollars). Define xi as the proportional change in X
on day i and y i as the proportional change in Y on day i . The proportional change in XY is
approximately xi yi . The standard deviation of xi is 0.018 and the standard deviation of y i
is 0.009. The correlation between the two is 0.4. The variance of xi yi is therefore
00182 00092 2 0018 0009 04 00005346
so that the volatility of xi yi is 0.0231 or 2.31%. This is the volatility of the FTSE
expressed in dollars. Note that it is greater than the volatility of the FTSE expressed in
sterling. This is the impact of the positive correlation. When the FTSE increases, the value of
sterling measured in dollars also tends to increase. This creates an even bigger increase in the
value of FTSE measured in dollars. Similarly, for a decrease in the FTSE.
23.13
Continuing with the notation in Problem 23.12, define zi as the proportional change in the
value of the S&P 500 on day i . The covariance between xi and zi is
07 0018 0016 00002016 . The covariance between y i and zi is
03 0009 0016 00000432 . The covariance between and zi equals the covariance
between xi and zi plus the covariance between xi yi y i and zi . It is
00002016 00000432 00002448
The correlation between xi yi and zi is
00002448
0662
0016 00231
Note that the volatility of the S&P 500 drops out in this calculation.
23.14
n2 VL un21 n21
so that
2n (1 )VL un21 2n1
2n 2n1 (1 )(VL 2n1 ) (un21 2n1 )
The variable un21 has a mean of n21 and a variance of
E (un1 )4 [ E (un21 )]2 2 n41
The standard deviation of un21 is 2 n21 .
We can write V n2 n21 and V n21 . Substituting for un21 into the equation for
n2 n21 , we get
V a(VL V ) Z
where Z is a variable with mean zero and standard deviation 2V . This equation defines
the change in the variance over one day. It is consistent with the stochastic process
dV a(VL V )dt 2Vdz
or
dV a(VL V )dt Vdz
when time is measured in days.
V a(VL V )t V t
Note that we are not assuming Z is normally distributed. It is the sum of many small changes
V t .
23.16
The parameter is in cell N3 of the EWMA worksheet for the previous problem is changed
to 0.97. VaR increases to $393,300 and ES increases to $450,590.
23.17
The proportional change in the price of gold is 4 600 000667 . Using the EWMA
model, the variance is updated to
094 00132 006 000667 2 000016153
so that the new daily volatility is 000016153 001271 or 1.271% per day. Using GARCH
(1,1), the variance is updated to
0000002 094 00132 004 0006672 000016264
so that the new daily volatility is 000016264 01275 or 1.275% per day.
23.18
The proportional change in the price of silver is zero. Using the EWMA model, the variance
is updated to
094 00152 006 0 00002115
so that the new daily volatility is 00002115 001454 or 1.454% per day. Using GARCH
(1,1), the variance is updated to
0000002 094 00152 004 0 00002135
so that the new daily volatility is 00002135 001461 or 1.461% per day. The initial
covariance is 08 0013 0015 0000156 . Using EWMA, the covariance is updated to
094 0000156 006 0 000014664
so that the new correlation is 000014664 (001454 001271) 07934 . Using GARCH
(1,1), the covariance is updated to
0000002 094 0000156 004 0 000014864
so that the new correlation is 000014864 (001461 001275) 07977 .
For a given and , the parameter defines the long run average value of a variance or a
covariance. There is no reason why we should expect the long run average daily variance for
gold and silver should be the same. There is also no reason why we should expect the long
run average covariance between gold and silver to be the same as the long run average
variance of gold or the long run average variance of silver. In practice, therefore, we are
likely to want to allow in a GARCH(1,1) model to vary from market variable to market
variable. (Some instructors may want to use this problem as a lead in to multivariate GARCH
models.)