Market Risk and the Concept of Fundamental Volatility

Soosung Hwang () and S. E. Satchell

Accounting and Finance Discussion Papers from Faculty of Economics, University of Cambridge

Abstract: This paper proposes the unobserved fundamental component of volatility as a measure of risk. This concept of fundamental volatility may be more meaningful than observed volatility for market regulators. Fundamental volatility may be obtained using a stochastic volatility model. The authors decompose four FTSE100 stock index related volatilities into transitory noise and unobserved fundamental volatility. The question as to whether derivative markets destabilise asset markets is addressed. The analysis shows that introducing European options reduces fun-damental volatility, while transitory noise in the underlying and futures markets does not show significant change. It is concluded that, for the FTSE100 index, introducing an options market has stabilised underlying and derivative markets.

Date: 1997-12
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