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Financial Market: Volatility Models Essay

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Why is Volatily Important?
Volatility is indispensable, and is central for pricing any asset within the financial market, from a single stock to the most complicated derivative. It is quite important when managing portfolios or in computing the risk or the corresponding hedging strategy, but the issue is that is not observable and it is heteroskedastic, it fluctuates through time, you should not assume a homoscedastic pattern, constant over time, because it will be a huge mistake when estimating. For that, enormous literature has put huge effort in trying to predict future volatility as accurately as possible, thus large number of sophisticated models has been created since the crucial study of Engle (1982), where he introduced the ARCH …show more content…

On the other hand, the Stochastic Volatility literature is one of the most well known statistical approaches for estimating future volatility.
Supplement approaches are those than connect specific information of the underlying, but the final estimation is only valid under that specifics assumptions. We could think about the Black & Scholes method for getting the price of an option, of the VaR model that requires the estimation of the volatility.
The papers that are presented below suggest that, in general, the GARCH model performs reasonable well in forecasting. Although there are some studies that find that the GARCH predictions are not so well, many authors have found later on that this bad performance was due to the bad specification of the ‘real’ volatility and not to the GARCH estimation per se, because the conditional variance of a financial series is an unobservable process, so there are some possible interpretations of what are you going to substitute in order to do the forecasting exercise. The literature presented in this paper also notices the differences when using different proxies for the conditional volatility.
This project is organized as follows; sections 2 to 5 are a simple summary of the key references that I have received. Section 6 includes some personal comments about the overall literature studied and finally, Section 7 is a briefly conclusion of the topic.

2. A Forecast Comparison Of Volatility Models:

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