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How Relevant is Volatility Forecasting for Financial Risk Management?

  • Peter F. Christoffersen
  • Francis X. Diebold

It depends. If volatility fluctuates in a forecastable way, then volatility forecasts are useful for risk management; hence the interest in volatility forecastability in the risk management literature. Volatility forecastability, however, varies with horizon, and different horizons are relevant in different applications. Moreover, existing assessments of volatility forecastability are plagued by the fact that they are joint assessments of volatility forecastability and an assumed model, and the results vary not only with the horizon, but also with the assumed model. To address this problem, we develop a model-free procedure for assessing volatility forecastability across horizons. Perhaps surprisingly, we find that volatility forecastability decays quickly with horizon. Volatility forecastability, although clearly of relevance for risk management at the short horizons relevant for, say, trading desk management, may not be important for risk management more generally.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6844.

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Date of creation: Dec 1998
Date of revision:
Publication status: published as Review of Economics and Statistics, Vol. 82 (2000): 12-23.
Handle: RePEc:nbr:nberwo:6844
Note: AP
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  9. Christoffersen, Peter F, 1998. "Evaluating Interval Forecasts," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 841-62, November.
  10. Anthony Santomero, 1997. "Commercial Bank Risk Management: An Analysis of the Process," Journal of Financial Services Research, Springer, vol. 12(2), pages 83-115, October.
  11. Engle, Robert F & Lilien, David M & Robins, Russell P, 1987. "Estimating Time Varying Risk Premia in the Term Structure: The Arch-M Model," Econometrica, Econometric Society, vol. 55(2), pages 391-407, March.
  12. West, K.D. & Cho, D., 1993. "The Predictive Ability of Several Models of Exchange Rate Volatility," Working papers 9317r, Wisconsin Madison - Social Systems.
  13. Lamoureux, Christopher G & Lastrapes, William D, 1990. "Persistence in Variance, Structural Change, and the GARCH Model," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(2), pages 225-34, April.
  14. Hamilton, James D. & Susmel, Raul, 1994. "Autoregressive conditional heteroskedasticity and changes in regime," Journal of Econometrics, Elsevier, vol. 64(1-2), pages 307-333.
  15. Hsieh, David A., 1993. "Implications of Nonlinear Dynamics for Financial Risk Management," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(01), pages 41-64, March.
  16. Francis X. Diebold & Til Schuermann & John D. Stroughair, 1998. "Pitfalls and Opportunities in the Use of Extreme Value Theory in Risk Management," Center for Financial Institutions Working Papers 98-10, Wharton School Center for Financial Institutions, University of Pennsylvania.
  17. Torben G. Andersen & Luca Benzoni, 2010. "Stochastic Volatility," CREATES Research Papers 2010-10, School of Economics and Management, University of Aarhus.
  18. Robert F. Engle & Che-Hsiung Hong & Alex Kane, 1990. "Valuation of Variance Forecast with Simulated Option Markets," NBER Working Papers 3350, National Bureau of Economic Research, Inc.
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  22. Jon Danielsson, 1997. "Extreme Returns, Tail Estimation, and Value-at-Risk," FMG Discussion Papers dp273, Financial Markets Group.
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  25. Torben G. Andersen & Tim Bollerslev, 1997. "Answering the Critics: Yes, ARCH Models Do Provide Good Volatility Forecasts," NBER Working Papers 6023, National Bureau of Economic Research, Inc.
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  27. Francis X. Diebold & Andrew Hickman & Atsushi Inoue & Til Schuermann, 1997. "Converting 1-Day Volatility to h-Day Volatitlity: Scaling by Root-h is Worse Than You Think," Center for Financial Institutions Working Papers 97-34, Wharton School Center for Financial Institutions, University of Pennsylvania.
  28. Engle, Robert F, 1982. "Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation," Econometrica, Econometric Society, vol. 50(4), pages 987-1007, July.
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