HOME Recent Events RMI in the News Notable Recognition ALUMNI
  Issue 29 | Archive November 2016

New Research Initiatives:

A Market Monitoring System for Forward Looking Returns and Volatilities

By Steven Kou (National University of Singapore)

In 2016, RMI embarked on three new research initiatives and this issue of the newsletter will discuss the third and final research initiative on developing a market monitoring system for forward looking returns and volatilities.

It will be useful for regulators to have indices that give continuous forecasts of forward looking returns and forward looking volatilities. However, currently there is no forward looking returns index and the only available forward looking volatility indices are VIX type indices of the Chicago Board Options Exchange (CBOE) Volatility Index. The problem with these VIX type indices is that many options, the number being around 100, are needed to compute the indices and these indices do not distinguish regular volatilities from jump volatilities. In view of this, RMI plans to build a system that gives daily updates of forward looking returns and volatilities, by combining information from both the return series and the associated derivative prices. The methodology behind this initiative is based on an academic paper by Kou, Peng, Sit, and Ying (2016), titled, ¡°Information from Options during the Crisis: An Empirical Likelihood Method of Combining Stock and Option Prices.¡± In particular, the study¡¯s empirical findings, obtained from a preliminary analysis of the S&P 500 Index and their derivative prices observed during the 2008 financial crisis, demonstrate the effectiveness of the new indices; for example, only four options are needed, and the method can report forward looking return forecast, and both jump volatility and regular volatility.

Modelling a financial series can usually be carried out directly based on the observed price levels/returns. However, in addition to return series, prices of actively traded derivatives, such as European call and put options, should also contain information about the parameters of the underlying process, due to the fact that these prices are derived upon model assumptions of the underlying asset, as pointed out by Lo and Wang (1995). If the information from both returns series and options can be combined, then one is expected to get more accurate, efficient, and (possibly) timely estimators. This feature is particularly useful during financial crises when the information from option markets can capture forward-looking information, instead of the backward-looking information contained in historical return series data.

The overall aim of this initiative is to build a system that provides a daily update of forward looking returns and volatilities for public listed companies and indices worldwide, as long as call and put options are available for them. The proposed system will enhance the ability for regulators to monitor markets in a timely way. Furthermore, once the indices are well developed, they may become part of standard financial infrastructures for global markets, like the VIX index, and be used as benchmark for financial contracts. Thus, the proposed system may help to promote Singapore as a host country of major think tanks for global financial markets. Additionally, researchers at RMI also plan study the related academic questions, and further the knowledge of quantitative finance. This will also enable RMI to train professionals in the area of finance, via degree programs and training courses, and create local talents who are ready to take part in the financial markets.

Back To Newsletter

Published quarterly by Risk Management Institute, NUS
Editor: Shivani Nakhare (rminsr@nus.edu.sg)