- #1
John Creighto
- 495
- 2
Options prices are often based upon the volatility of a stock. I'm left to wonder how we might estimate volatility. Let:
[tex]r[/tex] is the yearly expected rate of return
[tex]\sigma_r[/tex] is the uncertainty in the yearly expected rate of return.
[tex]\sigma_y[/tex] the daily volatility.
Then we might model the current price as follows:
[tex]y(n)=\sum_{i=1}^{\infty} w_i (r+\sigma_{r,i})^{(i-n)/365}(y(n-i)+\sigma_{y,i})[/tex]
where:
[tex]w_i[/tex] is how much weight we use each past value to determine the future value
and
[tex]1=\sum_{i=1}^{\infty} w_i[/tex]
Once the [tex]w_i[/tex]'s are chosen then [tex]r[/tex], [tex]\sigma_r[/tex] and [tex]\sigma_y[/tex] are chosen so that they minimize:
[tex]E \left[\left( y(n)-\hat{y}(n) \right)^2\right][/tex]
where:
[tex]\hat{y}(n)=\sum_{i=1}^{\infty} w_i E\left[(r+\sigma_{r,i})^{(i-n)/365}\right]y(n-i)[/tex]
[tex]r[/tex] is the yearly expected rate of return
[tex]\sigma_r[/tex] is the uncertainty in the yearly expected rate of return.
[tex]\sigma_y[/tex] the daily volatility.
Then we might model the current price as follows:
[tex]y(n)=\sum_{i=1}^{\infty} w_i (r+\sigma_{r,i})^{(i-n)/365}(y(n-i)+\sigma_{y,i})[/tex]
where:
[tex]w_i[/tex] is how much weight we use each past value to determine the future value
and
[tex]1=\sum_{i=1}^{\infty} w_i[/tex]
Once the [tex]w_i[/tex]'s are chosen then [tex]r[/tex], [tex]\sigma_r[/tex] and [tex]\sigma_y[/tex] are chosen so that they minimize:
[tex]E \left[\left( y(n)-\hat{y}(n) \right)^2\right][/tex]
where:
[tex]\hat{y}(n)=\sum_{i=1}^{\infty} w_i E\left[(r+\sigma_{r,i})^{(i-n)/365}\right]y(n-i)[/tex]
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