Predicting Risk Is Not Easy, But It Is Easier Than Predicting Returns
James Picerno | Aug 09, 2022 07:54AM ET
Predicting market risk is easier than predicting return, as demonstrated in the first instalment of this series. The caveat is that we shouldn’t conflate easier with easy. Nonetheless, a simple model of using yesterday’s return volatility proves to be a reliable forecast for today. The key question: how far into the future can we effectively forecast vol with this naïve model? The short answer: the reliability fades, quickly.
For perspective, keep in mind that a comparable degree of reliability with the same model with forecasting day-ahead returns would be a license to print money. Alas, Mr. Market doesn’t allow such things with performance data and so forecasting even a day-ahead based on the last data point is hopelessly random.
Volatility is another matter. The day-ahead forecast of return risk for the S&P 500 Index, for example, is highly reliable, as shown in the first chart below. It’s not perfect, but it’s close: the correlation between t+0 and t+1 vol is 0.991 since 1950 – a stone’s throw from a perfect score of 1.0.
Reliability takes a modest hit when the forecast is pushed out to 5 days, although the correlation is still high at 0.940.
The model starts to show significant breakdown at 10 days ahead, with correlation falling to 0.845.
Get The News You Want
At 20 days, the jig is up and we’ve got borderline noise via a correlation of 0.642.
The lesson seems to be that you can develop reasonably reliable vol forecasts for the S&P 500 out to 10-days or so, but by 20 you’ll need another model. Are forecasting analytics up to the job? We’ll explore some possibilities in the next update for this series.
Trading in financial instruments and/or cryptocurrencies involves high risks including the risk of losing some, or all, of your investment amount, and may not be suitable for all investors. Prices of cryptocurrencies are extremely volatile and may be affected by external factors such as financial, regulatory or political events. Trading on margin increases the financial risks.
Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. The data and prices on the website are not necessarily provided by any market or exchange, but may be provided by market makers, and so prices may not be accurate and may differ from the actual price at any given market, meaning prices are indicative and not appropriate for trading purposes. Fusion Media and any provider of the data contained in this website will not accept liability for any loss or damage as a result of your trading, or your reliance on the information contained within this website.
It is prohibited to use, store, reproduce, display, modify, transmit or distribute the data contained in this website without the explicit prior written permission of Fusion Media and/or the data provider. All intellectual property rights are reserved by the providers and/or the exchange providing the data contained in this website.
Fusion Media may be compensated by the advertisers that appear on the website, based on your interaction with the advertisements or advertisers.