Market risk and the concept of fundamental volatility: Measuring volatility across asset and derivative markets and testing for the impact of derivatives markets on financial markets

This paper proposes an unobserved fundamental component of volatility as a measure of risk. This concept of fundamental volatility may be more meaningful than the usual measures of volatility for market regulators. Fundamental volatility can be obtained using a stochastic volatility model, which all...

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Bibliographic Details
Published in:Journal of banking & finance 2000-05, Vol.24 (5), p.759-785
Main Authors: Hwang, Soosung, Satchell, Stephen E.
Format: Article
Language:English
Subjects:
Assets
Capital market
Financial risks
Fundamental volatility
Impact analysis
Implied volatility
Kalman filter
Market regulation
Options markets
Options on stocks
Risk
Securities markets
Stochastic models
Stochastic processes
Stochastic volatility model
Stock exchange
Stocks
Studies
Volatility
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Summary:This paper proposes an unobserved fundamental component of volatility as a measure of risk. This concept of fundamental volatility may be more meaningful than the usual measures of volatility for market regulators. Fundamental volatility can be obtained using a stochastic volatility model, which allows us to `filter’ out the signal in the volatility information. We decompose four FTSE100 stock index related volatilities into transitory noise and unobserved fundamental volatility. Our analysis is applied to the question as to whether derivative markets destabilise asset markets. We find that introducing European options reduces fundamental volatility, while transitory noise in the underlying and futures markets does not show significant changes. We conclude that, for the FTSE100 index, introducing a new options market has stabilised both the underlying market and existing derivative markets.
ISSN:0378-4266
1872-6372
DOI:10.1016/S0378-4266(99)00065-5