Using Historical Volatility To Gauge Future Risk
Volatility is critical to risk measurement. Generally, volatility refers to standard deviation, which is a dispersion measure. Greater dispersion implies greater risk, which implies higher odds of price erosion or portfolio loss - this is key information for any investor. Volatility can be used on its own, as in "the hedge fund portfolio exhibited a monthly volatility of 5%," but the term is also used in conjunction with return measures, as, for example, in the denominator of the Sharpe ratio. Volatility is also a key input in parametric value at risk (VAR), where portfolio exposure is a function of volatility. In this article, we'll show you how calculate historical volatility to determine the future risk of your investments.
Volatility is easily the most common risk measure, despite its imperfections, which include the fact that upside price movements are considered just as "risky" as downside movements. We often estimate future volatility by looking at historical volatility. To calculate historical volatility, we need to take two steps:
- Compute a series of periodic returns (e.g. daily returns)
- Choose a weighting scheme (e.g. unweighted scheme)
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