# Lecture Quantitative Finance

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1 Lecture Quantitative Finance Spring 2011 Prof. Dr. Erich Walter Farkas Lecture 12: May 19, 2011 Chapter 8: Estimating volatility and correlations Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture 12 1 / 49

2 1 Chapter 8: Estimating volatility and correlations Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture 12 2 / 49

3 Outline Chapter 8: Estimating volatility and correlations 1 2 Estimating volatility 3 The exponentially weighted moving average model 4 The GARCH (1,1) model 5 6 Using GARCH (1,1) to forecast future volatility 7 Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture 12 3 / 49

4 the goal of this chapter is to explain how historical data can be used to produce estimates of the current and future levels of volatilities and correlations this problem is relevant both to the calculation of value at risk and to the valuation of derivatives we consider the following models 1 exponentially weighted moving average (EWMA) 2 autoregressive conditional heteroscedascity (ARCH) 3 generalized A R C H (GARCH) the distinctive feature is that they recognize that volatilities and correlations are not constant during some periods, a particular volatility or correlation may be relatively low, whereas during other periods it may be relatively high the models attempt to keep track of the variations in the volatility or correlation through time Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture 12 4 / 49

5 to estimate the volatility of a stock empirically, the stock price is usually observed at fixed intervals of time (e.g. every day, week, or month) consider and let n + 1 : number of observations S i : stock price at end of the i th interval, with i = 0, 1,...n τ : length of time intervals in years ( ) Si u i = log S i 1 i = 1, 2,..., n the usual estimate s of the standard deviation of the u i is given by s = 1 n (u i u) 2 n 1 i=1 where u is the mean of u i σ can be estimated as σ = s τ the standard error or this estimate can be shown to be approximatively σ/( 2n) Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture 12 5 / 49

6 note that the usual estimate s of the standard deviation of the u i is given also by ( s = 1 n n ) 2 ui 2 1 u i n 1 n(n 1) i=1 i=1 where u is the mean of u i Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture 12 6 / 49

7 choosing an appropriate value for n is not easy more data generally lead to more accuracy, but σ does change over time and data that are too old may not be relevant for predicting the future volatility a compromise that seems to work reasonably well is to use closing prices from daily data over the most recent 90 to 180 days an often used rule of the thumb is to set n equal to the number of days to which the volatility is to be applied thus, if the volatility estimate is to be used to value a 2-year option, daily data for the last 2 years are used Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture 12 7 / 49

8 : Example A sequence of stock prices during 21 consecutive trading days: Day Closing stock price S i /S i 1 u i = log(s i /S i 1 ) In this case ui = and u 2 i = Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture 12 8 / 49

9 : Example the estimate of the standard deviation of the daily return is = or 1.216% assuming that there are 252 trading days per year, τ = 1/252 and the data give an estimate for the volatility per annum of the standard error of this estimate is = or 19.3% = or 3.1% per annum with dividend paying stocks: the return u i during a time interval that includes an ex-dividend day is given by where D is the amount of the dividend u i = log S i + D S i 1 Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture 12 9 / 49

10 : Trading days vs. calendar days an important issue is whether time should be measured in calendar days or trading days when volatility parameters are being estimated and used practitioners tend to ignore days when the exchange is closed when estimating volatility from historical data (and when calculating the life of an option) the volatility per annum is calculated from the volatility per trading day using the formula Vol per annum = Vol per tr. day nr. of tr. days per annum Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

11 : What causes volatility? it is natural to assume that the volatility of a stock is caused by new information reaching the market this new information causes people to revise their opinions about the value of the stock: the price of the stock changes and volatility results with several years of daily stock price date researchers can calculate: 1 the variance of the stock price returns between the close of trading on one day and the close of trading on the next day when there are no intervening nontrading days (in fact a variance of returns over a 1-day period) 2 the variance of the stock price returns between the close of trading on Friday and the close of trading on Monday (in fact a variance of returns over 3-day period) Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

12 : What causes volatility? we might be tempted to expect the second variance to be three times as great as the first variance but this is not the case (Fama 1965, French 1980, French and Roll 1980: second variance is respectively 22%, 19% and 10.7% higher than the first variance) it seems that volatility is to a large extent caused by trading itself (traders usually have no difficulty accepting this conclusion!) Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

13 Estimating volatility define σ n the volatility of a market variable on day n, as estimated at the end of day n 1 the square of the volatility σn 2 on day n is the variance rate the value of the market variable at the end of day i is S i recall the variable u i is defined as the continuously compounded return during day i (between the end of day i 1 and the end of day i): u i = log S i S i 1 an unbiased estimate of the variance rate per day, σ 2 n, using the most recent m observations on the u i is σ 2 n = 1 m 1 m (u n i u) 2 i=1 Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

14 Estimating volatility the mean u is given by u = 1 m u n i m i=1 recall an unbiased estimate of the variance rate per day, σn 2, using the most recent m observations on the u i is σ 2 n = 1 m 1 m (u n i u) 2 i=1 for the purposes of monitoring daily volatility the last formula is usually changed in a number of ways: Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

15 Estimating volatility 1 u i is defined as the percentage change in the market variable between the end of day i 1 and the end of day i, so that 2 u is assumed to be zero 3 m 1 is replaced by m u i = S i S i 1 S i 1 these three changes make very little difference to the estimates that are calculated but they allow us to simplify the formula for the variance rate to σn 2 = 1 m un i 2 m i=1 last equation gives equal weight to u 2 n 1, u2 n 2,..., u2 n m our objective is to estimate the current level of volatility σ n: it therefore makes sense to give more weight to recent data Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

16 Estimating volatility a model that does it is: m σn 2 = α i un i 2 i=1 ( ) the variable α i is the amount of weight given to the observation i days ago the numbers α i are positive if we choose them so that α i < α j when i > j, less weight is given to older observations the weights must sum up to unity, so we have m α i = 1 i=1 Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

17 Estimating volatility an extension of the idea in equation (*) is to assume that there is a long-run average variance rate and that this should be given some weight this leads to the model that take the form m σn 2 = γv L + α i un i 2 i=1 ( ) where V L is the long-run variance rate and γ is the weight assigned to V L because the weights must sum to unity, we have m γ + α i = 1 i=1 Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

18 Estimating volatility this is known as an ARCH (m) model and it was first suggested by Robert Engle in 1982 the estimate of the variance is based on a long-run average variance and m observation: the older an observation, the less weight it is given defining ω = γv L the model in equation (**) can be written m σn 2 = ω + α i un i 2 i=1 Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

19 The EWMA model the exponentially weighted moving average (EWMA) model is a particular case of the model in equation (*) where the weights α i decrease exponentially as we move back through time specifically α i+1 = λα i where λ is a constant between 0 and 1 it turns out that this weighting scheme leads to a particularly simple formula for updating volatility estimates: σ 2 n = λσ 2 n 1 + (1 λ)u2 n 1 (1) the estimate σ n is the volatility for day n (made of the end of day n 1) is calculated from σ n 1 (the estimate that was made at the end of day n 2 of the volatility for day n 1) and u n 1 (the most recent percentage change) Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

20 The EWMA model to understand why equation (1) corresponds to weights that decrease exponentially, we substitute for σn 1 2 to get σ 2 n = λ[λσ 2 n 2 + (1 λ)u2 n 2 ] + (1 λ)u2 n 1 or σ 2 n = (1 λ)(u2 n 1 + λu2 n 2 ) + λ2 σ 2 n 2 substituting in a similar way for σ 2 n 2 gives σn 2 = (1 λ)(u2 n 1 + λu2 n 2 + λ2 un 3 2 ) + λ2 σn 3 2 continuing in this way we see that m σn 2 = (1 λ) λ i 1 un i 2 + λm σn m 2 i=1 Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

21 The EWMA model recall m σn 2 = (1 λ) λ i 1 un i 2 + λm σn m 2 i=1 for large m the term λ m σn m 2 is sufficiently small to be ignored so that equation (1) is the same as equation (*) with α i = (1 λ)λ i 1 the weights for the u i decline at rate λ as we move back thorugh time; each weight is λ times the previous weight Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

22 The EWMA model: Example suppose that λ = 0.90, the volatility estimated for a market variable for day n 1 is 1% per day and during day n 1 the market variable increased by 2% this means σ 2 n 1 = = and u 2 n 1 = = equation (1) gives σn 2 = = the estimate of the volatility σ n for day n is therefore or 1.14% per day note that the expected value of un 1 2 is σ2 n 1 or in this example, the realized value of un 1 2 is greater than the expected value and as a result our volatility estimate increases if the realized value of un 1 2 had been less than its expected value, our estimate of the volatility would have decreased Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

23 The EWMA model the EWMA approach has the attractive feature that relatively little data need to be stored at any given time we need to remember only the current estimate of the variance rate and the most recent observation on the value of the market variable when we get a new observation on the value of the market variable, we calculate a new daily percentage change and use equation (1) to update our estimate of the variance rate the old estimate of the variance rate and the old value of the market variable can then be discarded the EWMA approach is designed to track changes in the volatility the Risk Metrics database, which was originally created by J. P. Morgan and made publicly available in 1994, uses the EWMA model with λ = 0.94 for updating daily volatility estimates in its RiskMetrics database the company found that, across a range of different market variables, this value of λ gives forecasts of the variance rate that come closest to the realized variance rate Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

24 The GARCH (1,1) model proposed by T. Bollerslev in 1986 the difference between GARCH (1,1) and EWMA is analogous to the difference between equation (*) and equation (**) in GARCH (1,1) σ 2 n is calculated from the long-run average variance rate V L as well as from σ n 1 and u n 1 the equation for GARCH (1,1) is σ 2 n = γv L + αu 2 n 1 + βσ2 n 1 where γ is the weight assigned to V L, α is the weight assigned to un 1 2 and β is the weight assigned to σ 2 n 1 the weights sum up to one γ + α + β = 1 Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

25 The GARCH (1,1) model the EWMA model is a particular case of GARCH (1,1) where γ = 0, α = 1 λ, β = λ the (1,1) in GARCH (1,1) indicates that σn 2 is based on the most recent observation of u 2 and the most recent estimate of the variance rate the more general GARCH (p,q) model calculates σ 2 n from the most recent p observations on u 2 and the most q estimates of the variance rate; GARCH (1,1) is by far the most popular of the GARCH models setting ω = γv L, the GARCH (1,1) model can also be written σ 2 n = ω + αu 2 n 1 + βσ2 n 1 the last form is usually used for the purposes of estimating the parameters for a stable GARCH (1,1) process we require α + β < 1, otherwise the weight term applied to the long-term variance is negative Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

26 The GARCH (1,1) model: Example suppose that a GARCH (1,1) model is estimated from daily data as σ 2 n = u2 n σ2 n 1 this corresponds to α = 0.13, β = 0.86 and ω = because γ = 1 α β it follows that γ = 0.01 because ω = γv L it follows that V L = in other words, the long-run average variance per day implied by the model is this corresponds to a volatility of = or 1.4% per day suppose that the estimate of the volatility on day n 1 is 1.6% per day, so that σ 2 n 1 = = and that on day n 1 the market variable decreased by 1% so that u 2 n 1 = = then σn 2 = = the new estimate of the volatility is therefore = or 1.53% Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

27 The GARCH (1,1) model: The weights as in the EWMA model we immediately get σ 2 n = ω + βω + β 2 ω + αu 2 n 1 + αβu2 n 2 + αβ2 u 2 n 3 + β3 σ 2 n 3 continuing in this was we see that the weight applied to u 2 n i is αβ i 1 the weights decline exponentially at rate β the parameter β can be interpreted as decay rate; it is similar to the λ in the EWMA model the GARCH (1,1) model is similar to the EWMA model except that, in addition to assigning weights that decline exponentially to past u 2 it also assigns some weight to the long-run average volatility Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

28 The GARCH (1,1) model: Mean reversion (optional part) the GARCH (1,1) model recognizes that over time the variance tends to get pulled back to a long-run average level of V L the amount of weight assigned to V L is γ = 1 α β the GARCH (1,1) is a equivalent to a model where the variance V follows the stochastic process dv = a(v L V )dt + ξvdz where time is measured in days, a = 1 α β and ξ = α 2; this is the mean reverting model the variance has a drift that pulls it back to V L at rate a when V > V L, the variance has a negative drift; when V L < V it has a positive drift Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

29 Choosing between the models in practice variance rates tend to be mean reverting the GARCH (1,1) model incorporates mean reversion, whereas the EWMA model does not GARCH (1,1) is therefore more appealing than the EWMA model a question that needs to be discussed is how best-fit parameters ω, α, β in GARCH (1,1) can be estimated when the parameter ω is zero, the GARCH (1,1) reduces to EWMA in circumstances where the best-fit value of ω turns out to be negative, the GARCH (1,1) model is not stable and it makes sense to switch to the EWMA model Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

30 how are the parameters estimated from historical data in the models we have been considering? the approach used is known as the maximum likelihood method it involves choosing values for the parameter that maximize the chance (or likelihood) of the data occuring Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

31 Estimating a constant variance problem: estimate the variance of a variable X from m observations on X when the underlying distribution is normal with zero mean we assume that the observations are u 1, u 2,... and that the mean of the underlying distribution is zero denote the variance with v the likelihood of u i being observed is the probability density function for X when X = u i this is ( ) 1 u 2 exp i 2πv 2v the likelihood of m observations occuring in order in which they are observed is [ m i=1 1 2πv exp ( u 2 i 2v using the maximum likelihood method, the best estimate of v is the value that maximizes this expression )] Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

32 Estimating a constant variance maximizing an expression is equivalent to maximizing the logarithm of the expression; taking logarithms and ignoring constant multiplicative factors, it can be seen that we wish to maximize [ ] m log v u2 i v i=1 differentiating this expression with respect to v and setting the result equation to zero, we see that the maximum likelihood estimator of v is 1 m m ui 2 i=1 Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

33 Estimating GARCH (1,1) parameters how can the likelihood method be used to estimate the parameters when GARCH (1,1) method or some other volatility update scheme is used? define v i = σi 2 as the variance estimated for day i we assume that the probability distribution of u i conditional on the variance is normal a similar analysis to the one just given shows the best parameters are the ones that maximize [ ( )] m 1 u 2 exp i 2πvi 2v i=1 i this is equivalent (taking logarithms) to maximizing [ ] m log v i u2 i v i=1 i this is the same expression as above, except that v is replaced by v i we search iteratively to find the parameters in the model that maximize the expression in (2) (2) Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

34 Estimation of GARCH (1,1) parameters: Example the data below analyses the Japanese yen exchange rate between January 6, 1988 and August 15, 1997 Date Day i S i u i v i = σ 2 i log(v i ) u 2 i /v i 06 Jan Jan Jan Jan Jan Jan Aug Aug Aug = Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

35 Estimation of GARCH (1,1) parameters: Example the fifth column shows the estimate of the variance rate v i = σi 2 at the end of day i 1 on day 3 we start things off by setting the variance equal to u2 2 on subsequent days, we use equation for day i made σ 2 n = ω + αu 2 n 1 + βσ2 n 1 the sixth column tabulates the likelihood measure log(v i ) u 2 i /v i the values in the fifth and sixth columns are based on the current trial estimates of ω, α and β: we are interested to maximize the sum of the members in the sixth column this involves an iterative search procedure in our example the optimal values of the parameters turn out to be ω = , α = , β = the numbers shown in the above table were calculated on the final iteration of the search for the optimal ω, α, and β the long-term variance rate V L in our example is ω 1 α β = = Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

36 Estimation of GARCH (1,1) parameters: Example when the EWMA model is used, the estimation procedure is relatively simple: we set ω = 0, α = 1 λ, and β = λ in the table above, the value of λ that maximizes the objective function is and the value of the objective function is both GARCH (1,1) and the EWMA method can be implemented by using the Solver routine in Excel to search for the values of the parameters that maximize the likelihood function Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

37 Using GARCH (1,1) to forecast future volatility the variance rate estimated at the end of day n 1 for day n, when GARCH (1,1) is used, is so that on day n + t in the future, we have σ 2 n = (1 α β)v L + αu 2 n 1 + βσ2 n 1 σ 2 n V L = α(u 2 n 1 V L) + β(σ 2 n 1 V L) σ 2 n+t V L = α(u 2 n+t 1 V L) + β(σ 2 n+t 1 V L) the expected value of u 2 n+t 1 is σ2 n+t 1 hence E[σ 2 n+t V L ] = (α + β)e[σ 2 n+t 1 V L] using this equation repeatedly yields or E[σ 2 n+t V L ] = (α + β) t (σ 2 n V L ) E[σ 2 n+t ] = V L + (α + β) t (σ 2 n V L) this equation forecasts the volatility on day n + t using the information available at the end of the day n 1 Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

38 Using GARCH (1,1) to forecast future volatility in the EWMA model, α + β = 1 and the last equation shows that the expected future variance rate equals the current variance rate when α + β < 1 the final term in the equation becomes progressively smaller as t increases as mentioned earlier, the variance rate exhibits mean reversion with a reversion level of V L and a reversion rate of 1 α β our forecast of the future variance rate tends towards V L as we look further and further ahead this analysis emphasizes the point that we must have α + β < 1 for a stable GARCH (1,1) process when α + β > 1 the weight given to the long-term average variance is negative and the process is mean fleeing rather than mean reverting Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

39 Using GARCH (1,1) to forecast future volatility in the yen-dollar exchange rare example considered earlier α + β = and V L = suppose that our estimate of the current variance rate per day is (this corresponds to a volatility of 0.77% per day) in 10 days the expected variance rate is ( ) = the expected volatility per day is 0.74%, still well above the long-term volatility of per day however the expected variance rate in 100 days is ( ) = and the expected volatility per day is 0.667% very close to the long-term volatility Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

40 the discussion so far has centered on the estimation and forecasting of volatility correlations play a key role in the computation of VaR the goal of this last section is to show how correlation estimates can be updated in a similar way to volatility estimates recall the covariance between two random variables X and Y is defined as E[(X µ X )(Y µ Y )] where µ X and µ Y are respectively the means of X and Y the correlation between two random variables X and Y is cov(x, Y ) σ X σ Y where σ X and σ Y are the two standard deviations of X and Y and cov(x, Y ) is the covariance between X and Y Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

41 define x i and y i as the percentage changes in X and Y between the end of the day i 1 and the end of day i: x i = X i X i 1 X i 1 and y i = Y i Y i 1 Y i 1 where X i and Y i are the values of X and Y at the end of the day i we also define σ x,n : daily volatility of variable X estimated for day n σ y,n : daily volatility of variable Y estimated for day n cov n : estimate of covariance between daily changes in X and Y, calculated on day n our estimate on the correlation between X and Y on day n is cov n σ x,nσ y,n Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

42 using an equal-weighting scheme and assuming that the means of x i and y i are zero, as before we can estimate the variance rates of X and Y from the most recent m observations as σx,n 2 = 1 m xn i 2 and σy,n 2 m = 1 m yn i 2 m i=1 i=1 a similar estimate for the covariance between X and Y is cov n = 1 m x n i y n i m i=1 Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

43 one alternative for updating covariances is an EWMA model as previously discussed the formula for updating the covariance estimate is then cov n = λcov n 1 + (1 λ)x n 1 y n 1 a similar analysis to that presented for the EWMA volatility model shows that the weights given to observations on the x i and y i decline as we move back through time the lower the value of λ, the greater the weight that is given to recent observations Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

44 : Example assume λ = 0.95 and that the estimate of the correlation between two variables X and Y on day n 1 is 0.6 assume that the estimate of the volatilities for the X and Y on day n 1 are 1% and 2% respectively from the relationship between correlation and covariance, the estimate fo the covariance between X and Y on day n 1 is = suppose that the percentage changes in X and Y on day n 1 are 0.5% and 2.5% respectively the variance and covariance for day n would be updated as follows: σ 2 x,n = = σ 2 y,n = = Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

45 : Example the new volatility of X is = 0.981% the new volatility of Y is = 2.028% the new coefficient of correlation between X and Y is = Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

46 GARCH models can also be used for updating covariance estimates and forecasting the future level of covariances for example the GARCH (1,1) model for updating a covariance is cov n = ω + αx n 1 y n 1 + βcov n 1 and the long-term average covariance is ω/(1 α β) similar formulas to those discussed above can be developed for forecasting future covariances and calculating the average covariance during the life time of an option Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

47 Consistency condition for covariances once all the variances and covariances have been calculated, a variance-covariance matrix can be constructed when i j, the (i, j) element of this matrix shows the covariance between variable i and j; when i = j it shows the variance of variable i not all variance-covariance matrices are internally consistent; the condition for an N N variance-covariance matrix Ω to be internally consistent is w T Ω w 0 for all N 1 vectors w, where w T is the transpose of w; such a matrix is called positive-semidefinite to understand why the last condition must hold, suppose that w T is (w 1,..., w n); the expression w T Ω w is the variance of w 1 x w nx n where x i is the value of the variable i; as such it cannot be negative to ensure that a positive-semidefinite matrix is produced, variances and covariances should be calculated consistently Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

48 Consistency condition for covariances to ensure that a positive-semidefinite matrix is produced, variances and covariances should be calculated consistently for example, if variances are calculated by giving equal weight to the last m data items, the same should be done for covariances if variances are updated using an EWMA model with λ = 0.94 the same should be done for covariances an example of a variance-covariance matrix that it is not internally consistent is the variance of each variable is 1.0 and so the covariances are also coefficients of correlation the first variable is highly correlated with the third variable and the second variable is highly correlated with the third variable however there is no correlation at all between the first and the second variables; this seems strange; when we set w equal to (1, 1, 1) we find that the positive semi-definiteness condition above is not satisfied proving that the matrix is not positive-semidefinite Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

49 Reference Book: Options, futures and other derivatives Author: John Hull Sixth Edition, Prentice Hall, 2006 Chapter 19: Estimating Volatilities and, pages Prof. Dr. Erich Walter Farkas Quantitative Finance 11: Lecture / 49

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