Volatility - Definition
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Volatility in finance refers to the degree at which the securitys price in the market moves up or down for a certain period of time. To measure volatility, you can use the variance or the standard deviation between returns from either the same market index or security. The securitys price in the market becomes riskier when the volatility is high. Generally, volatility is a metric used by investors in the stock exchange market to gauge how risky security maybe.
A Little More on What is a Volatility
Stock exchange markets always experience big swings in the securitys price value in either direction at some point. Volatility usually gets attention when there is economic turbulence. The reason is that during economic turbulence, most investors go through a situation of uncertainty because of the rapid swings in the shares price value, creating a volatile market. The term volatile market comes into existence when there is either a price value rises or falls in the stock market above 1% over a given period of time. Note that there is potential for the value of a security to spread out over a wide range of values when the volatility is higher. It means that the securitys price can swiftly change over a short span of time in any of the two directions (upward or downward). On the other hand, lower volatility has no dramatic fluctuation in the securitys price value, meaning that the prices are a bit steady. Investors use the Volatility Index (VIX) to check market volatility. Chicago Board Options Exchange came up with the VIX metric. The metric was for gauging the 30-day anticipated volatility of the United States stock market derived from the S$P 500 put and call options real-time quote. Investors can use it to effectively gauge anticipated future outcomes, as far as the direction of the markets and securities are concerned.
More about Volatility
Note that some items are more volatile than others. For instance, individual shares are usually considered to be more volatile compared to a stock-market index that contains different types of stocks. So, to avoid higher risks, lower risk investors usually prefer investing in securities that have less volatility risk because there is a guarantee of returns. Again to understand volatility better, investors will always assess a securitys beta. The beta gives an approximation of the overall security returns volatility against the relevant benchmarks returns. Capital Asset Pricing Model uses volatility to make a comparison in the wider market. It also uses it to determine the expected assets returns based on its beta, as well as its market returns expectations.
Types of Volatility
There are various types of volatility. They include the following:
- Price Volatility
Price volatility comes into existence as a result of three factors. These factors bring about swift swings in demand and supply. Some of these swings include:
- Seasonability: This is where prices increase or decrease in a given season. A good example is where prices of hotel room rise during the winter season as they are usually on demand as people try to escape the snow. However, the same hotel rooms prices will go down during the summer season when people can manage to stay at their homes. In this example, price fluctuation is a result of a change in demand.
- Weather: Weather can also affect volatility in the market. For instance, the price of agricultural produce relies on the supply. So, when the weather is favorable, it may lead to bountiful harvesting of crops meaning that there will be enough supply hence steady prices. On the other hand, less harvest means that there will be scarcity in supply leading to price fluctuations.
- Emotions: The prices of commodities can also experience turbulence. It can happen when there are worries among investors regarding the volatility riks involved in whatever they want to buy.
A good example is when the U.S. and Europe in January 2012 threatened to put sanctions against Iran for creating weapons-grade uranium. To retaliate, Iran threatened to close the Hormuz Straits to restrict oil supply. The fact that the oil supply was not affected, oil traders did increase the price of oil barrel to $110 in March that very year. Now, to avoid slowing down Chinas economy, they again lowered the price of the oil barrel to $80 per barrel.
- Stock Volatility
According to investors, the stock is a risky investment due to its unpredictable returns. This is the reason why some stocks price is usually highly volatile. Due to the return uncertainty of such stock, high-risk investors usually demand higher returns. So, those firms with high volatile stocks have no choice but to ensure that they double their profits to be able to pay investors the high dividends.
- Historical Volatility
Historical volatility shows the history of stock volatility for the past twelve months. Through historical volatility, investors are able to learn the stock price variance in the previous year. If the volatility history is less attractive, then the firm has to wait until the stocks price normalizes so that it can sell it at a profitable price. However, because of unpredictability, a stock that is highly volatile may happen to go down further before it picks up again.
- Implied Volatility
Implied volatility shows options traders the degree of stocks volatility in the future. The traders are able to tell the stocks implied volatility by looking at the variances rates in the future options prices. Where there is an increase in options prices, it may be an indication that there is an increase in implied volatility, as other things remain equal. How is implied volatility important? The thing is that when an investor feels that a stock will get more volatile in the near future, he can buy an option on the stock. If the prediction was correct, the price of this option will increase, and an investor can go ahead to sell it at a profitable price. In other words, you can sell an option, if you feel that it will be less volatile in the future so that you can make a profit when you sell it.
- Market Volatility
Market volatility is where the changes in price in a given market become rapid. The changes in prices may include forex, commodities, and stock. When there is market volatility, it is an indication that there is either an upward or downward price movement in the market. So, when the market becomes volatile, bullish traders tend to increase prices on commodities on what they regard to be a good news day. On the other hand, bearish traders, as well as short-sellers, take advantage of this to bring prices down on what they term as a bad news day.
Factors that Affect Volatility
- National and regional factors
Under national and regional factors, we have things such as tax as well as interest rate policies, which are factors that may affect volatility. Policies that touch on tax and interest rates can bring significant changes in the market, thus affecting the volatility of that particular market. For instance, lets say a central bank decides to set the short-term interest rates for overnight borrowing by regional banks. When this happens, there will be fierce reactions in their stock market.
- Changes in Inflation trends and Industry Factors
Changes in inflation trends as well as in industry can also affect market trends of the long-term stock as well as its volatility. For example, if there happens to be a major weather change in a major oil-producing region, it can lead to an increase in the prices of oil. The situation may lead to a hike in the price of oil-related items.
References for Volatility
Academic research for Volatility
Expected stock returns and volatility, French, K. R., Schwert, G. W., & Stambaugh, R. F. (1987). Expected stock returns and volatility. Journal of financial Economics, 19(1), 3-29. Modeling and forecasting realized volatility, Andersen, T. G., Bollerslev, T., Diebold, F. X., & Labys, P. (2003). Modeling and forecasting realized volatility. Econometrica, 71(2), 579-625. Emerging equity market volatility, Bekaert, G., & Harvey, C. R. (1997). Emerging equity market volatility. Journal of Financial economics, 43(1), 29-77. Why does stock market volatility change over time?, Schwert, G. W. (1989). Why does stock market volatility change over time?. The journal of finance, 44(5), 1115-1153. Measuring and testing the impact of news on volatility, Engle, R. F., & Ng, V. K. (1993). Measuring and testing the impact of news on volatility. The journal of finance, 48(5), 1749-1778. 5 Stochastic volatility, Ghysels, E., Harvey, A. C., & Renault, E. (1996). 5 Stochastic volatility. Handbook of statistics, 14, 119-191. Transmission of volatility between stock markets, King, M. A., & Wadhwani, S. (1990). Transmission of volatility between stock markets. The Review of Financial Studies, 3(1), 5-33. The crosssection of volatility and expected returns, Ang, A., Hodrick, R. J., Xing, Y., & Zhang, X. (2006). The crosssection of volatility and expected returns. The Journal of Finance, 61(1), 259-299. Monetary policy and asset price volatility, Bernanke, B., & Gertler, M. (2000). Monetary policy and asset price volatility (No. w7559). National bureau of economic research. The distribution of realized exchange rate volatility, Andersen, T. G., Bollerslev, T., Diebold, F. X., & Labys, P. (2001). The distribution of realized exchange rate volatility. Journal of the American statistical association, 96(453), 42-55.