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Forecasting Volatility in the Financial Markets

Quantitative Finance Series

Aims and Objectives books based on the work of financial market practitioners, and academics presenting cutting edge research to the professional/practitioner market combining intellectual rigour and practical application covering the interaction between mathematical theory and financial practice to improve portfolio performance, risk management and trading book performance covering quantitative techniques

MarketBrokers/Traders; Actuaries; Consultants; Asset Managers; Fund Managers; Regulators; Central Bankers; Treasury Officials; Technical Analysts; and Academics for Masters in Finance and MBA market.

Series TitlesReturn Distributions in Finance Derivative Instruments Managing Downside Risk in Financial Markets Economics for Financial Markets Performance Measurement in Finance Real R&D Options Forecasting Volatility in the Financial Markets, Third Edition Advanced Trading Rules, Second Edition Advances in Portfolio Construction and Implementation Computational Finance Linear Factor Models in Finance Initial Public Offerings Funds of Hedge Funds Venture Capital in Europe

Series Editor Dr Stephen SatchellDr Satchell is the Reader in Financial Econometrics at Trinity College, Cambridge; Visiting Professor at Birkbeck College, City University Business School and University of Technology, Sydney. He also works in a consultative capacity to many firms, and edits the journal Derivatives: use, trading and regulations and the Journal of Asset Management.

Forecasting Volatility in the Financial MarketsThird editionEdited by

John Knight Stephen Satchell

AMSTERDAM BOSTON HEIDELBERG LONDON NEW YORK OXFORD PARIS SAN DIEGO SAN FRANCISCO SINGAPORE SYDNEY TOKYOButterworth-Heinemann is an imprint of Elsevier

Butterworth-Heinemann is an imprint of Elsevier Linacre House, Jordan Hill, Oxford OX2 8DP, UK 30 Corporate Drive, Suite 400, Burlington, MA 01803, USA First edition 1998 Second edition 2002 Third edition 2007 Copyright 2007 Elsevier Ltd. All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher Permissions may be sought directly from Elseviers Science & Technology Rights Department in Oxford, UK: phone (+44) (0) 1865 843830; fax (+44) (0) 1865 853333; email: permissions@elsevier.com. Alternatively you can submit your request online by visiting the Elsevier web site at http://elsevier.com/locate/permissions, and selecting Obtaining permission to use Elsevier material Notice No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data A catalogue record for this book is available from the Library of Congress ISBN13: 978-0-7506-6942-9 ISBN10: 0-7506-6942-X For information on all Butterworth-Heinemann publications visit our web site at http://books.elsevier.com

Printed and bound in The Netherlands 07 08 09 10 11 10 9 8 7 6 5 4 3 2 1

Working together to grow libraries in developing countrieswww.elsevier.com | www.bookaid.org | www.sabre.org

M01 ReleaseContents

List of contributors Preface to third edition Introduction 1 Volatility modelling and forecasting in finance Linlan Xiao and Abdurrahman Aydemir What good is a volatility model? Robert F. Engle and Andrew J. Patton Applications of portfolio variety Dan diBartolomeo A comparison of the properties of realized variance for the FTSE 100 and FTSE 250 equity indices Rob Cornish An investigation of the relative performance of GARCH models versus simple rules in forecasting volatility Thomas A. Silvey Stochastic volatility and option pricing George J. Jiang Modelling slippage: an application to the bund futures contract Emmanuel Acar and Edouard Petitdidier Real trading volume and price action in the foreign exchange markets Pierre Lequeux Implied risk-neutral probability density functions from option prices: a central bank perspective Bhupinder Bahra

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10 Hashing GARCH: a reassessment of volatility forecasting performance George A. Christodoulakis and Stephen E. Satchell

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Contents

11 Implied volatility forecasting: a comparison of different procedures including fractionally integrated models with applications to UK equity options Soosung Hwang and Stephen E. Satchell 12 GARCH predictions and the predictions of option prices John Knight and Stephen E. Satchell 13 Volatility forecasting in a tick data model L.C.G. Rogers 14 An econometric model of downside risk Shaun Bond 15 Variations in the mean and volatility of stock returns around turning points of the business cycle Gabriel Perez-Quiros and Allan Timmermann 16 Long memory in stochastic volatility Andrew C. Harvey 17 GARCH processes some exact results, some difficulties and a suggested remedy John L. Knight and Stephen E. Satchell 18 Generating composite volatility forecasts with random factor betas George A. Christodoulakis

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Index

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List of contributors

E. Acar Bank of America, UK A.B. Aydemir Family and Labour Studies Division, Statistics Canada, Ottawa, Canada B. Bahra Bank of England, UK S. Bond University of Cambridge, Cambridge, UK G.A. Christodoulakis Faculty of Finance, Manchester Business School, UK R. Cornish Global Asset Management Ltd, London, UK D. diBartolomeo Northfield Information Services, Inc., Boston, USA R.F. Engle Stern School of Business, New York University, USA A.C. Harvey Faculty of Economics, University of Cambridge, UK S. Hwang Cass Business School, London, UK G.J. Jiang Finance Department, Eller College of Business and Public Administration, University of Arizona, USA J.L. Knight Department of Economics, University of Western Ontario, Canada P. Lequeux Banque Nationale de Paris plc, London, UK Linlan Xiao Department of Economics, University of Western Ontario, Canada A.J. Patton Financial Markets Group, London School of Economics, UK

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List of contributors

G. Perez-Quiros Federal Reserve Bank of New York, USA E. Petitdidier Systeia Capital Management, Paris, France L.C.G. Rogers Department of Mathematics, University of Cambridge, UK S.E. Satchell Faculty of Economics, Trinity College and University of Cambridge, UK T.A. Silvey Trinity College, Cambridge, UK A. Timmermann Department of Economics, University of California, San Diego, USA

Preface to third edition

The third edition of this book includes the earlier work in the first two editions plus five new chapters. One of these five chapters is a contribution by Professor Rob Engle; we are honoured to include his work. This chapter is written jointly with Andrew Patton. We also have a research piece by one of the worlds leading risk practitioners, Dan diBartolomeo, Principal of Northfield and a valued contributor to many international conferences. The remaining new chapters are by three young promising researchers, Rob Cornish, Linlan Xiao and Tom Silvey. We hope readers enjoy the new edition. Both editors were pleased by the popularity of the first two editions and valued the feedback received.

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Introduction

This book presents recent research on volatility in financial markets with a special emphasis on forecasting. This literature has grown at a frightening rate in recent years, and would-be readers may feel daunted by the prospect of learning hundreds of new acronyms prior to grappling with the ideas they represent. To reduce the entry costs of our readers, we present two summary chapters; a chapter on volatility in finance by Linlan Xiao and A.B. Aydemir, and a survey of applications of stochastic volatility models to option pricing problems by G.J. Jiang. This is an area of some importance, as one of the sources of data in the study of volatility is the implied volatility series derived from option prices. As mentioned previously, we are delighted to reproduce a paper by Professor Engle written jointly with A. Patton. We include a number of practitioner chapters, namely one by D. diBartolomeo, one by R. Cornish, one by E. Acar and E. Petitdidier, and one by P. Lequeux. We have a chapter by a monetary economist, B. Bahra. All these chapters focus on practical issues concerning the use of volatilities; some examine high-frequency data, others consider how risk-neutral probability measurement can be put into a forecasting framework. We have a number of chapters concentrating on direct forecasting using GARCH, forecasting implied volatility and looking at tick-by-tick data. These chapters concentrate much more on theoretical issues in volatility and risk modelling. S. Bond considers dynamic models of semi-variance, a measure of downside risk. G. Perez-Quiros and A. Timmermann examine connections between volatility of stock markets and business cycle turning points. A. Harvey examines long memory stochastic volatility, while J. Knight and S. Satchell consider some exact properties of conditional heteroscedasticity models. T. Silvey answers a question, very vexing to theorists, as to why simple moving average rules for for

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