About the Website and the CD

The purpose of this book is to teach the reader to design and implement their own models of the relationships between important variables in financial markets. With this aim in mind, a CD has been provided that contains examples of many of the models that are described in the text. Most of the chapters have an associated spreadsheet that illustrates how important parameters, such as volatility, and important quantities, such as option prices or value-at-risk, may be obtained using the models described. These spreadsheets contain individual help files that explain their use, with references to the text that covers the technical background of the model. The password for these files is available from http: www.wiley.co.uk/marketmodels.

The reader may wish to use the programs as a basis for their own working models, but it should be stressed that the CD is provided free and for educational purposes only. It is not guaranteed to work and no additional software or hardware support will be given to the user. Neither are the spreadsheets guaranteed to be free of errors. Any errors should be reported to the market models user discussion forum that will be provided on the website for the book: http: www.wiley.co.uk/marketmodels. It is hoped that this forum will provide a means for users to exchange ideas on the aspects of model development that are covered in the text.

There are approximately 230 figures in this book, and more than a few have had their glorious Technicolor suppressed by the confines of monochrome print. An appealing feature of the CD is that it contains the original colour versions of these figures and, in most cases, the supporting data. The password for these files is available from http: www.wiley.co.uk/marketmodels. The CD includes free demonstration versions of commercial software that are particularly relevant to the subjects covered in the book, in addition to the Market Models spreadsheets mentioned above. An asterisk * is placed in the list of contents to indicate the sections that have associated software on the CD.

Carol Alexander

July 2001

WILEY COPYRIGHT INFORMATION AND TERMS OF USE

CD supplement to Market Models: A Guide to Financial Analysis Copyright © 2001 Carol Alexander

Published in 2001 by John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, P019 8SQ, England All rights reserved.

Additional copyright information:

Excel Workbooks: Copyright Carol Alexander reproduced with permission of Steffen Hennig and Sujit Narayanan where joint authorship applies Universal Add-ins: Copyright MBRM reproduced with permission of Mamdouh Barakat

PcGive: Copyright Jurgen A. Doornik and David F. Hendry reproduced with permission

PCA: Copyright Ubbo F. Wiersema reproduced with permission

All material contained within this CD product is protected by copyright, whether or not a copyright notice appears on the particular screen where the material is displayed. No part of the material may be reproduced or transmitted in any form or by any means, or stored in a computer for retrieval purposes or otherwise, without written permission from Wiley, unless this is expressly permitted in a copyright notice or usage statement accompanying the materials. Requests for permission to store or reproduce material for any purpose, or to distribute it on a network, should be addressed to the Permissions Department, John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, P019 8SQ, England, telephone +44 (0) 1243 770347; email: permissions@wiley.co.uk

Neither the authors nor John Wiley & Sons Ltd accept any responsibility or liability for loss or damage occasioned, directly or indirectly, to any person, business or property through using the materials, instructions, methods or ideas contained herein, or acting or refraining from acting as a result of such use. The authors and Publisher expressly disclaim all implied warranties, including merchantability or fitness for any particular purpose. There will be no duty on the authors or Publisher to correct any errors or defects in the software.

Parti

Volatility and Correlation Analysis

Part I provides insights into the pricing and hedging of options through the understanding of volatility and correlation, and the uncertainty which surrounds these key determinants of portfolio risk. The first chapter introduces volatility and correlation as parameters of the stochastic processes that are used to model variations in financial asset prices. They are not observable in the market and can only be measured in the context of a model.

Option pricing, which models asset prices in continuous time, is covered in Chapter 2. This chapter focuses on the consequences of using the Black-Scholes model to price options. Although there can only be one true volatility for the underlying price process, different volatilities are implied by the market prices of options on the same underlying asset. If one is willing to accept these volatilities, rather than invent better option pricing models, then their behaviour can be described by modelling the smile or skew patterns that emerge. The relationship between underlying price changes and changes in the implied volatility of an option is analysed to support the use of different volatility assumptions for pricing and hedging.

Statistical forecasts of volatility and correlation employ discrete time series models on historical return data. Chapter 3 explains how to obtain moving average estimates of volatility and correlation and outlines their advantages and limitations. A weighted average is a method for estimation. The current estimate of volatility or correlation is sometimes used as a forecast, but this requires returns to be independent and identically distributed, an assumption which is not always supported by empirical evidence. Chapter 4 introduces generalized autoregressive conditional heteroscedasticity (GARCH) models, which are based on more realistic assumptions about asset price dynamics. This chapter aims to cut through a vast academic literature on the subject to present the concepts and models that are most relevant to practitioners. A step-by-step guide to the implementation of the GARCH models that are commonly used by risk managers and investment analysts is followed by a description of the application of GARCH models to option pricing and hedging.