## Solution to Question 2 from UoL exam 2019, zone B

Suppose the parameters in a GARCH (1,1) model

(1)

are , the index refers to days and is zero-mean white noise with conditional variance .

(a) What are the requirements for this process to be covariance stationary, and are they satisfied here? [20 marks]

If the coefficients satisfy the condition for positivity, , then the condition for covariance-stationarity is . They are barely satisfied.

(b) What is the long-run average volatility? [20 marks]

We use the facts that for all *t*. Applying the unconditional mean to regression (1) and using the LIE we get

and

.

(c) If the current volatility is 2.5% per day, what is your estimate of the volatility in 20, 40, and 60 days? [20 marks]

On p.107 of the Guide there is the derivation of the equation

(2)

I gave you a slightly easier derivation in my class, please use that one. If we interpret "current" as and "in twenty days" as , then

For use the same formula to get 0.016692, 0.013725, resp. I did it in Excel and don't envy you if you have to do it during an exam.

(d) Suppose that there is an event that decreases the current volatility by 1.5%to 1% per day. Estimate the effect on the volatility in 20, 40, and 60 days. [20 marks]

Calculations are the same, just replace 0.025 by 0.01. Alternatively, one can see that the previous values will go down by , which results in volatility values 0.012146, 0.009934 and 0.008125.

(e) Explain what volatility should be used to price 20-, 40-and 60-day options, and explain how you would calculate the values. [20 marks]

The only unobservable input to the Black-Scholes option pricing formula is the stock price volatility. In the derivation of the formula the volatility is assumed to be constant. The value of the constant should depend on the forecast horizon. If we, say, forecast 20 days ahead, we should use a constant value for all 20 days. This constant can be obtained as an average of daily forecasts obtained from the GARCH model.

If the GARCH is not used, a simpler approach is applied. If the average daily volatility is , then assuming independent returns, over a period of days volatility is .

In practice, traders go back from option prices to volatility. That is, they use observed option prices to solve the Black-Scholes formula for volatility (find the root of an equation with the price given). The resulting value is called **implied volatility**. If it is plugged back into the Black-Scholes formula, the observed option price will result.