Historical price data (or better financial time series data) is used to generate return estimates, which are

used to estimate volatility. Volatility estimation methods usually weight past information equally across times. Volatility is generally considered synonymous to risk.

Statistically speaking volatility means the conditional variance of the underlying asset return. Modeling of volatility of any historical data can improve the efficiency in parameter estimation and the accuracy in interval forecast.

PROPERTIES OF VOLATILITY Volatility cluster exists Volatility evolves over time in a continuous manner. Volatility does not diverge to infinity. Volatility reacts to sharp fluctuations in asset prices.

EWMA (Exponential Weighted Moving Average) model is a specific case of the general weighted model. This model is named on the rational that weights are assume to decline exponentially back through time.

EWMA model implies that the time period n volatility estimate is a function of volatility calculated at time period t-1. Higher the value of the parameter will minimize the effect of daily percentage returns, whereas low values will tend to increase the effect of daily percentage return on the current volatility estimate.

The dynamics of EWMA are able to capture the impact of daily returns on the volatility . Thus by using very few data we can estimate volatility through this formula.

Problem 1 The parameter of an EWMA is estimated to be 0.9. Daily standard deviation is estimated to be 1.5% and return on the security is 0.8%. What is the new etimate of volatility?

ARCH (Autoregressive Conditional Hetroscedasticity) is one of the primary method, which is used to capture Volatility. This model was incepted by Engle (1982). As the name suggests, unequal variances may have an autoregressive structure in that hetroscedasticity observed over different periods may be autocorrelated.

ARCH model postulates that volatility in the current period is related to its previous value in the previous period plus a white noise error term. The regression coefficients are judged here usually through t tests, however z tests are also used for this in few cases.

The ARCH model is based upon following equations yt =tt t2 = + yt-12

ARCH model was further generalized by Bollerslev (1986), by the introduction of GARCH (p,q) model. The most parsimonious form of this model is GARCH (1,1) order model, which is, to the date, most frequently used. This model can be given by following equations. yt =tt Mean Equation