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Robert Engle
Stern School of BusinessSIEPR February 26,2009
WHAT I S H A PPEN ING TO
FIN ANC IA L M ARK ET
VOLAT I L I T Y AN D WHY ?
WHA T I S H A PPEN ING TO
FIN ANC IA L M ARK ET
VOLAT I L I T Y AN D WHY ?
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RISK
A Risk is a bad future event that mighthappen.
Some risks can be avoided completely. But some risks are worth taking because
the possible benefit exceeds the possiblecosts.
Finance investigates which risks are worthtaking.
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NOBEL A N SWERS
Markowitz (1952) and Sharpe(1964) andTobin (1958) received Nobel awards in
1990 and 1981 for associating risk withthe variance of financial returns.
Capital Asset Pricing Model or CAPManswer: Only variances that could not bediversified would be rewarded.
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B LA CK -SCHOLES AN D M ERTON
Options can be used as insurancepolicies. For a fee we can eliminatefinancial risk for a period.
What is the right fee? Black and Scholes(1972) and
Merton(1973) developed an option pricingformula from a dynamic hedgingargument. Their answer also satisfies the
CAPM. They received the Nobel prize in 1997
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I M PLEM EN T ING TH ESEMODELS
Practitioners required estimates ofvariances and covariances or equivalently
volatilities and correlations.
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EST IM A T ES D IFFER FORD IFFERENT T IM E PERIODS
Volatility is apparently varying over time
What is the volatility now? What is it likely to be in the future?
How can we forecast something we never
observe?
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ARCH MODEL
The ARCH model predicts the variance ofreturns on the next day.
It relies on two features of returns Volatility Clustering
Mean Reversion of Volatility Econometric Methods fit this model to
data
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P lu s a n d M in u s t h r e e S i gm a
- . 1 00
-. 0 75
-. 0 50
-. 0 25
. 0 00
. 0 25
. 0 50
. 0 75
. 1 00
9 0 9 2 9 4 9 6 9 8 0 0 0 2 0 4 0 6
3 *S P V O L S P R E T -3 *S P V O L
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OBSERVAT IONS
CONFIDENCE INTERVAL IS CHANGING GREEN CURVE IS APPROXIMATELY VAR
.6% RETURNS EXCEED INTERVAL LARGEST IS -6.8 SIGMA! (oct 27 1997)
MORE EXTREMES THAN EXPECTED FOR A
NORMAL BUT NOT FOR A STUDENT-T
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DOES TH I S WORK I N TU RBU LEN T T IMES?
ESTIMATE THROUGH 2004 KEEPING SAME PARAMETERS,
FORECAST TO END OF SAMPLE ONEDAY AT A TIME.
DO WE SEE MULTI-SIGMA MOVES?
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P lu s a n d M i n u s 3 x s i gm a u s i n g 2 0 0 4 m o d e l
- . 1 5
- . 1 0
- . 0 5
.0 0
.0 5
.1 0
.1 5
2 0 0 5 2 0 0 6 2 0 0 7 2 0 0 8
3 *D J S D 0 4 D J R E T -3 *D J S D 0 4
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STANDARDIZED RETU RNS SIN CE 20 04U SING 20 0 4 EST IM A TED MODEL
0
40
80
120
160
200
240
-8 -6 -4 -2 0 2
Series: DJ RET/DJ SD04Sample 1/03/2005 10/20/2008Observations 956
Mean -0.001066Median 0.063605Maximum 3.004820Minimum -7.536694Std. Dev. 1.053278
Skewness -0.665960Kurtosis 5.993653
J arque-Bera 427.6494Probability 0.000000
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WHAT WAS -7 S IGMA EV EN T ?
-8
-6
-4
-2
0
2
4
2 0 0 5 2 0 0 6 2 0 0 7 2 0 0 8
D J R E T /D J S D 0 4
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SURPR IS IN G SUCCESS
Although the original application of ARCHwas macroeconomic, the big success was
for financial data.
Why does it work?
What makes volatility high?
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WHY DO PR ICES CH ANGE?
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B ET T ER AN SWER
Economic news on future values and risksmoves prices
Volatility is the natural response of afinancial market to new information.
News arrives in clusters. High volatility means a cluster of important
news!
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VOLAT I L I T Y
Through February 20,2009
VLAB http://vlab.stern.nyu.edu
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S& P 5 0 0 GARCH
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ONE Y EAR TA RCH a n d V IX
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ADDING Y ESTERDAY
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RANGE B A SED GARCH U SINGA SYMM ETR IC M EM FOR DA X
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CORPORA TE BONDS
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MSC I WORLD INDEX
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MSCI EM ERGING M ARK ET INDEX
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COMMOD IT I ES
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ENERGY , F IN A NCE, T ECHNOLOGY
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SECTOR CORRELA T ION S
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I N T ERN A T IONA L CORRELA T IONS
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WHERE I S VOLA T I L I T Y TODA Y ?
For most assets, volatility last fall wasdramatically above levels since 1990 but
is now somewhat lower. In the US, I think this is due
A) Macroeconomic uncertainty
B) Credit problems particularly associatedwith securitized debt.
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TH E SPL IN E GARCH MODEL OFLOW FREQUENCY V OLA T I L I TY A ND IT S M ACROECONOM IC
CAUSES
Robert Engle and Jose Gonzalo RangelReview of Financial Studies 2008
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MODEL LOW FREQUENCYVOLAT I L I T Y
For what countries is this greatest? For what time periods is it greatest?
What macroeconomic variables areassociated with volatility?
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WHA T M AK ES F IN AN CIA L M ARK ET VOLAT I L IT Y H IGH ?
High Inflation Slow output growth and recession
High volatility of short term interest rates High volatility of output growth
High volatility of inflation
Small or undeveloped financial markets
Large countries
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WERE WE PREPARED?
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TH REE VOLAT I L I T Y EP ISODES
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DOW J ONES 1 9 2 8 -2 0 0 8
-.3
-.2
-.1
.0
.1
.2
30 40 50 60 70 80 90 00
D J R E T
DJ CLOSE
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400
200
160
120
100
80
60
40
20
1930 1932 1934 1936 1938 1940
DJ CLOSE
VOLCOMP
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0
20
40
60
80
100
120
1930 1932 1934 1936 1938 1940
VOLCOMP
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DJ VOLAT I L I T Y 1 9 8 0 -1 9 9 0
0
20
40
60
80
100
120
140
160
80 81 82 83 84 85 86 87 88 89 90
D J V O L _ C O M P
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AND FOR 1 9 9 8 -2 0 0 8 ? WHA T CAN WE EX PECT ?
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DJ VOLAT I L I T Y 1 9 9 8 -2 0 0 8
0
1 0
2 0
3 0
4 0
5 0
6 0
7 0
9 8 9 9 0 0 0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8
V O L C O M P P E R M
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TH E R I SK OF WAR an d TERROR ISM
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A LONG RUN R I SK
Deteriorating Global Economy Increasing income differential between
rich and poor countries
Rising fundamentalism
Rising social unrest
Increase the risk of War and Terrorism
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DEPRESSED A SSET PR ICES
Long run risks lower asset prices asinvestors are more cautious.
This raises the cost of doing business andraising capital
This reduces income of entrepreneurs
And costs jobs
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WHAT TO DO?
PROMOTE PEACE MANY, MANY APPROACHES THROUGH POLITICS,
SCIENCE, MEDICINE, CULTURE, EDUCATION, LAW
SOME ECONOMIC PROPOSALS: TRADE CAPITAL FLOWS
BUILD ECONOMIC INTERDEPENDENCES
FIGHT POVERTY REFORM EDUCATION to show value in cooperation
PEACE PERMITS PROSPERITY
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BENEF I TS
Reducing future risk of war Yields benefits today by
Improving business and stock marketvaluations and
Creating jobs
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V ERY LONG RUN R ISK S ! ARE WE READY FOR TH ESE?
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GLOBA L OVERHEA T ING WHA T A RE TH E R I SK S?
Scientific evidence seems clear that theclimate is changing.
CO2
concentrations are rising rapidly
Glaciers and polar ice are melting
Warmest years on record are almost all within
10 years.
But what are the costs? Scientific
evidence is not precise.
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ECONOM IC COSTS
THE GLOBAL ECONOMY WILL BE UNABLETO PRODUCE AS MUCH IN THE FUTURE ASIT WOULD WITHOUT CLIMATE CHANGE
TAXES WILL BE RAISED TO PAY FORPUBLIC EFFORTS TO MITIGATE THESECOSTS
COMPANIES WILL HAVE EXTRA COSTS OFDOING BUSINESS SO PROFITS WILL BE
LOWER.
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FI NAN CI A L M ARK ET EVA LU AT ION OF CL IMA TE R ISK . I S CL IM A TE R ISK PRICED?
Can we see evidence of climate risk in financialmarkets? We would expect that stock prices would be
depressed by climate risk. If it is a risk for all stocks, then it would imply
simply a lower price. If it is more of a risk for some companies or
countries than others, then they would havebigger discounts.
If these risks are not priced, then there could be
profitable portfolio strategies.
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A SOLU T ION
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A SOLU T ION
Most Economists believe the best solutionto global overheating is a comprehensivetax on carbon emissions and othergreenhouse gases.
Only if it is comprehensive will it encourage
alternative energy solutions Only if it is comprehensive will efforts to avoid
the tax be socially beneficial.
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TA X REVENUE MU ST B E PARTOF TH E AN A LY SI S
Send a check to every resident for an equalfraction of the total revenue. This compensates everyone equally so it offsets the hardship
of an emissions tax for low incomes.
Send the checks first. It will enable people to buy fuel efficient cars, insulate homes,
improve appliance efficiency. This will stimulate industries thathave been badly hurt by the financial crisis.
After recession is over, invest passively in a sovereignfund to support social security and public health care.
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H ig h O i l Pr i c e s a r e a Go o d T h i n g !
These encouraged consumers andindustry to use less oil
Driving in the US was down
Hybrid Cars were selling and SUVs were not
House prices in the suburbs were declining
more than in the central city Ridership on public transportation was up
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B u t t h i s i s N o t En o u g h .
Oil prices are falling again. Coal is still a cheap and dirty alternative.
Entrepreneurs with ideas for alternativeenergy sources cannot be confident thatenergy prices will stay high.
Businesses and Consumers will hesitatebefore making energy investments
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CONCLUS ION
Make sure you take only the risks youintend to take
Keep an eye on long run risks
Policy makers remember: reducing longrun risks gives benefits today
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The first European conference will be held in GenevaJune 10th, 11th, and 12th, 2009.
Information about submitting papers can be found at the following webpage:
http://www.nyu.edu/sofie/
FoundingCouncil
John CampbellFrank DieboldRobert Engle
Ronald GallantRen Garcia
John GewekeEric Ghysels
Christian GourirouxClive Granger
Lars Peter HansenWolfgang HrdleRavi Jagannathan
Eric RenaultGeorge Tauchen
Halbert White
The Society is a global network of academics and practitionersdedicated to the fast-growing field of financial econometrics.
The Society will be associated with theJournal of Financial
Econometrics.
The Society for Financial EconometricsThe Society for Financial Econometrics
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