Thursday, August 16, 2012

A simple way to simulate volatility clustering

Nearly a year ago I have mentioned an important characteristic of financial markets returns, i.e. volatility clustering.

This phenomenon was analyzed by Benoit Mandelbrot and presented in a work he co-authored: "A Multifractal Model of Asset Returns".

Volatility clustering is closely connected with heteroscedasticity (existence of periods of different variance) of financial times series. It can be said that volatility clustering is a special case of heteroscedasticity of time series. In presence of volatility clustering, variance is not only variable, but tends to cluster in time.

As I've mentioned in my previous post, volatility clustering needs to be addressed by risk management. But that's not all. It is also important in development of quantitative investment models, which should recognize and adapt to changes in volatility.

The simplest solution is to get rid of hetorscedasticity by normalizing the data:


But is is even more important, to understand what is really going on under the hood. For that you can generate a time series demonstrating volatility clustering behavior. Since you have full control over the simulated data, you can easily experiment with it and look for effects you can trade on.

MMAR is definitely a superior approach to simulate behavior of financial data, but sometimes a much simpler approach may be enough:

[ R code ]

4 comments:

Kayal said...

I thought this blog admin is having well experienced because these posts are very creativity and very depth explanation. Thanks for sharing the unique details about this topic.
Linux Training in Chennai
Linux Course in Chennai
Best Linux Training Institute in Chennai
Excel Training in Chennai
Oracle Training in Chennai
Unix Training in Chennai
Corporate Training in Chennai
Embedded System Course Chennai
Oracle DBA Training in Chennai
Primavera Training in Chennai

Vicky Ram said...

Excellent post! keep sharing such a post

Article submission sites
Technology

janakikrishnan said...

The blog exposes lots of things to learn about this topic. Very useful things given by the author.
Java Training in Bangalore
Java Course in Bangalore
Java Training in Madurai
Java Course in Madurai
Java Training in Coimbatore
Java Classes in Coimbatore

EZaccounting said...

Thanks for sharing a good article with us. It is very helpful to us, if you want to know more about accounting software our website is helpful to you...
Accounting Software Singapore
PSG Grant Accounting Software
E invoicing Singapore