Volatility

Volatility is standard deviation of a financial instrument with a specific time horizon. It is often used to quantify the risk of the instrument over that time period. Volatility is typically expressed in annualized terms.

For a financial instrument whose return (finance) follows a Gaussian random walk, or Wiener process, the volatility increases by the square-root of time as time increases. Conceptually, this is because there is an increasing probability that the instrument's price will be farther away from the initial price as time increases. Mathematically, this is a direct result of applying Itô's lemma to the random process.

Defined

The annualized volatility σ is proportional to standard deviation σ_SD of the instrument's returns by the square-root of time period of the returns:

$\sigma = {\sigma_{SD}\over\sqrt{P}}$ ,

where P is time period in years of returns. The generalized volatility σ_T for time horizon T is expressed as:

$\sigma_T = \sigma \sqrt{T}$ .

For example, if the daily returns of a stock have a standard deviation of 0.01 and there are 252 trading days in a year, then the time period of returns is 1/252 and annualized volatility is

$\sigma = {0.01 \over \sqrt{1/252}} = 0.1587$ .

The monthly volatiliy (i.e., T = 1 / 12 of a year) would be

$\sigma_{month} = 0.1587 \sqrt{1/12} = 0.0458$ .

Volatility

Defined

See also