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Dr. Alex Castaldo

 

 

20-Feb-2006
Two Books on Academic Volatility Research

Half of the 2003 Nobel prize in economics was given to R.F.Engle "for methods of analyzing economic time series with time-varying volatility" (with the other half to Clive Granger "for methods of analyzing economic time series with common trends (co integration)"). Since Engle discovered ARCH models on a trip to England in 1979 there has developed a large (and probably excessive) research literature that tries to refine and extend these models. There has been a proliferation of models with names like GARCH, EGARCH, IGARCH and so on. What is the value of this research to investors?

The basic ideas are simple enough:

P. Rossi, ed: "Modeling Stock Market Volatility," Academic Press, 1996

This book is a collection of advanced research papers written during the boom phase of volatility research. Daniel Nelson (of the University of Chicago) is the author of more than half of these papers, he is joined by well known authors such as Engle himself, Hansen, Bollerslev and others. The papers' mathematics are very advanced, at the frontiers of econometrics; I have not been able to fully work through any of the 14 chapters! Most of the book is taken up by proofs of various results.

It is difficult to know what value, if any, this book will have in the long run. One chapter "ARCH models as diffusion approximations" has already become somewhat well known. The author shows that there is a relationship between the ARCH models of Engle and stochastic volatility models (such as Heston's) that are used in option research; that is important theoretically, and it is not too surprising since they are trying to model the same phenomena in different ways (discrete time in the former case, continuous time in the latter). Chapter 3, which introduced the EGARCH model, is probably important. For the other chapters, it is impossible to judge now how important its contribution will be without being an expert in the field. The final chapters, for example one about bond option pricing, don't seem to fit very well in a book about stock market volatility.

Probably the only way to make money from this book is to avoid buying it. It belongs in university libraries or on the shelves of a few researchers who need proofs of certain theoretical results. Most of the material would seem to belong in research journals rather than a book, although I can understand the decision to honor Daniel Nelson by publishing it after his death.

S-H. Poon: A Practical Guide to Forecasting Financial Market Volatility, Wiley, 2005

This book is addressed to a more general audience than the previous one. It is an expanded version of a survey article published in 2003 and tries to give an overview of the huge amount of volatility research of the last few years. It promises in some sense to be the antidote to the Rossi book.

The author has reviewed 93 published articles dealing with volatility forecasting. These are listed in an appendix, together with a telegraphic summary of the findings (for example: Tse and Tung (1992) looked at the Singapore market from 1975 to 1988, the best vol. forecast was EWMA, the next best the Historical Vol., GARCH was last). Looking at this appendix it is clear that the Implied Volatility from the option markets is often the best or one of the best forecasts of Vol. The market can often do a better job than the models.

The book starts with a review of the definition of volatility and some of its basic properties. There is a chapter on forecast evaluation, including the new Diebold-Mariano technique that has attracted a lot of attention. This is followed by chapters on ARCH and related vol. models. Finally a discussion of option pricing and risk management in light of these models.

I found this book useful in learning the latest academic thinking about vol., even though it is not as readable or well organized as it could be (with sometimes too little detail and sometimes too much, and some jumping around between topics). It does not cover how to actually estimate Arch models (for that the Diebold book's appendix, recommended by the Chair, can be used), and it is more "academic" than "practical" despite its title. But it is an informative and useful book.

 

 

Alessandro Castaldo, CFA, is a researcher and trader for Manchester Trading. Dr. Castaldo wrote his PhD dissertation on stock market volatility at the City University of New York, and taught courses in finance and options to undergraduates at Baruch College (CUNY) from 1998-2001. He has been associated with Circle T Partners, LP, a $400 million equity hedge fund; and Willowbridge Associates, a $1 billion-plus commodities trading adviser, where his responsibilities included the ongoing refinement of a market-neutral statistically based ("stat-arb") stock selection model.  Dr. Castaldo holds a B.S. in electrical engineering/computer science and an M.S. in management from the Massachusetts Institute of Technology, and worked as a software engineer at SEI Corporation/TMI Systems, Software Research Corp. and Systems Constructs Inc. before entering the finance profession.

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