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In this part of our Knowledge Series, we present the difference between Historical (Realized) and Implied Volatility. We take a couple of examples of Coffee and Sugar and see how their Historical and Implied volatilities moved over a period of time.
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Knowledge Series: Realised & Implied Volatility
© 2014 | All Rights Reserved Page 1
Knowledge Series: Realised & Implied Volatility
© 2014 | All Rights Reserved Page 2
Introduction
This article is in continuation to our last Knowledge Series article wherein I wrote about the basics of
Volatility and the standard ways of calculating it. In this article, I will further distinguish between
Realised and Implied Volatility. Of late, at Risk Edge we are being frequently asked about the role of
Implied Volatility in Risk Management. So this article differentiates between the two - ‘Realised
Volatility’ generally called ‘Historical Volatility’ and the ‘Implied Volatility’.
Realised Volatility
Realised Volatility of an asset, as the name suggests is an estimate of the fluctuation observed in the
daily prices of the asset, represented in % terms. It is usually calculated on the daily close prices. In
some cases when the commodity benchmark price is not reported by a well known agency or an
illiquid commodity, daily average price is used for estimating the Realised Volatility. Our Knowledge
Series article on Volatility shows the standard ways of calculating Realised Volatility. The simplest
way of calculating Realised Volatility is the Standard Deviation.
𝑆𝐷 = 𝑥𝑖 − 𝑥 2𝑛
𝑖=1
𝑛 − 1 (1)
Implied Volatility (IV)
Implied Volatility (IV) on the other hand is the volatility “implied” from the option prices or a
Volatility Index (like VIX). It is seen as a general indication of what the market’s future volatility
would be. Observing Implied Volatility from Option prices is the common practice. Since most option
trade volume is usually in the at-the-money (ATM) Options, IV is derived from the prices of ATM
Options.
In simplest terms, knowing the ATM option price we could derive IV using the option pricing model
like Black-Scholes. I.e., the Volatility that results in the ‘known’ Option price will be the IV of the
Underlying; such IV will be in annualised terms (i.e., daily volatility × 252) and has to be scaled
down for the expiration period. Most price data providers and exchanges publish the implied
Volatility estimates regularly.
Knowledge Series: Realised & Implied Volatility
© 2014 | All Rights Reserved Page 3
Illustration
On 4th Aug 2014, ICE ARABICA COFFE FUTURES near month i.e, SEP 14 settled at 190.5 Cents/lb. And
the ATM Option 190.00 CALL SEP 14 settled at 5.83 Cents/lb, suggesting an implied Volatility of
51.26%. Assuming the price returns are normally distributed and have a zero average return, the two
Volatility estimates suggest two price ranges with 68% probability, for the underlying futures
contract ICE COFFEE SEP 14.
Realised Volatility: The one day Conditional EWMA Volatility is 2.8% suggesting a probable
price range of 185 – 196 Cents/lb. This is the expected price range of Coffee Futures if one
were to assume that the recently observed price variance will continue to be the same on
the next day as well.
Implied Volatility: The IV estimate for one day is 3.2% suggesting a probable range of 184 –
197 Cents/lb. On the other hand market participants think the price could be anywhere in
this range (68% probable)
Figure 1: Understanding what Realised & Implied Volatilities suggest
Like in this example, it is observed that mostly the implied volatility surface for a wide range of
options averages to a value greater than the realised volatility. This premium can be seen as
compensation to option sellers for the unlimited risk they are taking. Generally, the higher the IV,
the higher the Option Premium.
To summarize, Realised Volatility represents the past variance and Implied Volatility gives a sense of
the future volatility. Realised Volatility is used as a cue for option trading, by assuming that the past
Knowledge Series: Realised & Implied Volatility
© 2014 | All Rights Reserved Page 4
volatility will repeat in future. But there could be a bias as it depends on the market conditions of
the particular sample period which was used for observing Volatility. While both the volatilities are
generally used as tools for option trading, there have been studies showing that Implied Volatility is
better at predicting the short-term future volatility. Spread between these two Volatilities is also
used as a trading cue. Such strategies are called Volatility arbitrage strategies, wherein the trader for
example buys options (straddles let’s say) at low Volatility and sells at high Volatility.
Following is a chart of Implied and Realised Volatilities of ICE Arabica Coffee Futures near month.
Figure1: Implied vs Realised Volatility Trend Chart of Coffee at ICE
Knowledge Series: Realised & Implied Volatility
© 2014 | All Rights Reserved Page 5
This is an interesting example where the Implied Volatility for most part has been at par or lesser
than the Realised Volatility. That means the Option’s market price is less than the theoretical price
on such days and that the market participants perceived the future volatility to be lower than the
Realised Volatility. However a look at the trend over last 5 years tells us that the IV was largely at a
premium over RV during 2009-12.
Knowledge Series: Realised & Implied Volatility
© 2014 | All Rights Reserved Page 6
Following is a snapshot of Implied v/s Realised Volatility trend in ICE RAW SUGAR near month
contract during the same period.
Knowledge Series: Realised & Implied Volatility
© 2014 | All Rights Reserved Page 7
Volatility for Risk Management
Volatility is used for Risk Management – VaR computation, Derivative Pricing, hedging strategies and
in general for commodity procurement and sales decisions. Both Realised and Implied Volatilities are
used for Pricing, Hedging & Trade Strategies. For VaR Computation though, Realised Volatility is
generally used. In our next publication, we’ll analyse empirically if using Implied Volatility for VaR
brings additional benefits when compared to using the Realised Volatility. The idea is to check if we
can compute VaR considering the market’s perception of future Volatility. Some organizations use IV
for hedging decisions and for them, it will be important that the trading, hedging and risk
management decisions are all taken based on the same inputs.
About the Author: Santoshi Ippili
Santoshi has worked extensively in the Commodity Risk Management Domain for over 8 years and
has been instrumental in developing and implementing risk management software solutions for
several Fortune 2000 companies. She holds a post-graduate degree in Finance from BITS Pilani. At
RES, she is responsible for research and business analysis of the latest tools and techniques in Risk
Management and bringing them in a structured way into the product. She can be reached
Knowledge Series: Realised & Implied Volatility
© 2014 | All Rights Reserved Page 8
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