LEVEL: INTERMEDIATE
The volatility of a security is defined as the change in the asset in percentage terms on an annualized basis. Most investors are cognizant of volatility as it relates to returns on their portfolio especially if the market is moving lower. Volatility can be gauged in many ways and there are a number of popular matrixes that are used to monitor volatility risk.
Measuring Volatility
Most investors view volatility as a measure of an adverse move of their portfolio. In fact, volatility pertains to both upward movements in a security as well as downward movements of a security. The most common way to measure volatility is to determine the standard deviation of the returns of a financial instrument or portfolio.
The reason volatility risk is important is that investors should be paid as the risk increases. Risk is directly related to volatility and increases along with increases in the volatility of a security. There are a number of ways to measure the volatility of a portfolio which include matrices such as the Sharpe Ratio, the Information Ratio and the Sortino Ratio.
Sharpe Ratio
William Sharpe created a metric in an effort to measure the accuracy of a portfolio relative to the volatility of the underlying returns. The Sharpe ratio measures risk-adjusted returns and divide this metrics by the standard deviation of the average-returns.
• Sharpe Ratio = (X – Y) / Z
• Where X = The average return on the portfolio
• Y = Risk-free rate
• Z = Volatility of Returns
The Sharpe ratio measures the average-return after subtracting the risk free rate, divided by the portfolio’s standard deviation.
Information-ratio:
The Information-ratio is also an attempt to improve on the Sharpe ratio. The difference within the ratios lies in the numerator which is average return minus a rate. The Sharpe ratio uses a risk free rate while the Information-ratio uses a benchmark that is more closely associated with the portfolio such as the S&P 500 in the case of a long only equity portfolio.
Sortino Ratio:
The Sortino attempts to improve upon the Sharpe ratio by removing the penalty associated with upside volatility. The Ratio examines the average return minus the risk free rate of return (identical to the Sharpe ratio) but then divides it by the negative standard deviation, which measures only negative volatility.
Historical Volatility
Historical volatility is measured as the standard deviations of a specific period calculated on an annualized basis. For example, a historical volatility of 30% reflects a security that has moved 30% from one point to another over the course of a year.
When a financial security has a higher volatility relative to a comparable benchmark, the security is described as having a high beta.
Beta
The beta of the security is a measurement in which the number reflects its relationship to its benchmark, with the number 1, reflecting a neutral reading. A security with a beta of 1 would move in tandem with its benchmark. A security that is less than one is less volatile than its market benchmark, while beta’s that are greater than 1 are more volatile than their benchmark.
The Treynor ratio is a matrix that compares to the volatility of the portfolio relative to its beta. The beta measures portfolios sensitivity to returns. The Treynor ratio is very good to use as a tool when adding a stock to a portfolio of stocks.
Hedging
The volatility risk of a portfolio can be hedge with a number of financial instruments including options and indexes. Options are the right but not the obligation to purchase or sell as security at a specific price on or before a certain date. An option is priced based on implied volatility which assists in the process of hedging volatility risk. Implied volatility risk is known as the Vega or a security.
To hedge a portfolio of stock, and invest can use a put option which give the investor the right to sell a security or index and therefore would protect the investor against an adverse move in stocks.
Vega
The value of an option is determined by many factors, which include the perception of how much a specific security will move over a certain period of time. Market participants value this by determining the implied volatility of a security. The implied volatility is a forward looking concept, which is the amount a security will move in percentage terms over a specific period on an annualized basis.
The exposure and options trader has to implied-volatility is referred to as Vega. A long Vega position means that a trader benefits as implied volatility rises. A short Vega positions benefits when implied volatility of a security falls. Generally owners of calls and puts are long Vega as their option values decline if implied volatility drops.
Another way an investor can hedge their volatility risk is by purchasing an index that fluctuates along with volatility. For example, the VIX volatility index moves in tandem with the implied volatility of the S&P 500 index at the money strike prices and is a good index to use to mitigate volatility risk. There are a number of exchange traded funds that are highly correlated to the VIX volatility index and are used by portfolio managers to hedge volatility risk exposure.