Volatility Estimate via Fourier Analysis

Emilio Baru i
E-mail: ebaru ie .unipi.it
Dipartimento di Statisti a e Matemati a
Appli ata all'E onomia, Universita di Pisa

Maria Elvira Man ino

E-mail: man inopaley.dm.unipi.it
DIMAD, Universita degli Studi di Firenze

Roberto Reno
E-mail: reno ibs.sns.it
S uola Normale Superiore, Pisa
and INFM, Italy
June,14 2000

Abstra t 1 Introdu tion

In this paper we apply a new method, based on In this paper we implement the methodology pro-
Fourier analysis, to ompute ross volatilities on posed in [12℄ to estimate multivariate volatility for
histori al data. The main feature of su h a method nan ial time series when the data are observations
is to be based on an integration pro edure instead of a ve tor of ontinuous time semi-martingales.
of a dierentiation one. On equally spa ed data The methodology is based on Fourier Analysis, it
(daily, weekly) it provides the same result than the allows for time varying, eventually sto hasti oeÆ-
lassi al method. However it is best suited for high ients. Volatility for diusion pro esses is a on ept
frequen y data, sin e it does not rely upon an ag- well dened in theory but very diÆ ult to be esti-
gregation or interpolation of the data. The method mated empiri ally for nan ial time series. In fa t,
has been tested on Monte Carlo simulations, and nan ial data are not observed in ontinuous time.
some results on real data are shown. Many estimators of the volatility with onstant o-
eÆ ients have been onstru ted in the e onometri -
statisti of pro esses literature. The methods are
based on dierentiation of the observations, i.e., the
expe tation of the quadrati movements of the time
series is omputed; instead, our approa h is based
Keywords: Volatility, orrelations, high fre- on integration. This feature allows us to avoid some
quen y data diÆ ulties en ountered with lassi al methods, ex-
pe ially with high frequen y data, see [5℄.
Our method is almost model free, it makes very
weak assumptions on the market model. The
method is semi-parametri , no assumption on the
fun tional form of the volatility is done. These fea-
tures render our method well suited to dete t the

1
dynami s of volatility. We normalize the time window for the omputation
To test the methodology, we provide both a of the volatility to [0; 2℄. In [12, Theorem 1.2℄ it
Monte Carlo analysis re onstru ting the volatiltiy is shown that the Fourier oeÆ ients of  an be
of a given pro ess and we apply it to real data. In omputed by means of the Fourier oeÆ ients of
both ases we ompare the results to those obtained du, then lassi al results of Fourier theory allows
with lassi al methods. We perform univariate and us to re onstru t (t) 8t 2 [0; 2℄.
multivariate tests. First of all, we onsider a univariate setting. The
The Monte Carlo analysis establishes that the Fourier oeÆ ients of du are
method performs well in omputing the volatility
of a theoreti al pro ess and in re onstru ting the a (du) = 
R 
1
du(t)
2

ross volatilities of two pro esses.

0
R 2 0
ak (du) =  os(kt)du(t)
2
(3)
1

In Se tion 2 we present the methodology devel- bk (du) = 1

R 0
2
sin(kt)du(t):
oped in [12℄. In Se tion 3 we relate our approa h 0

to related literature. In Se tion 4 we present some

te hni al points asso iated with the implementa- Then we obtain the Fourier oeÆ ients of 
tion of the methodology. In Se tion 5 we perform a through the formulas:
Monte Carlo analysis of the method testing its per-
forman e in re onstru ting the volatility of a theo- n
X 1 a (du) + b (du)

reti al pro ess. Se tion 6 is devoted to the appli a- () = nlim 
!1 n + 1
2 2

tion of the method to nan ial time series.

a0
n0
s= n0
2 s s

(4)
2 The Methodology ak () = lim
2 n
X
( ) ( )
n!1 n + 1
as du as+k du
n0
s=n0
The methodology developed in [12℄ needs only the (5)
following assumption about the market model: the 2 n
quadrati variation of the e onomi time series of () = nlim
X
( ) ( )
interest (pri es, returns, volumes et .) must be lim-
bk
!1 n + 1 n0
s=n0
bs du bs+k du :

ited. One popular example of su h models is the (6)

diusion pro ess: By the lassi al Fourier-Fejer inversion formula, we
X an re onstru t (t):
dui (t) = ij (t)dWj (t) + i (t)dt i = 1; : : : ; N;
j n
X
(1) !1 k (1 n )
(ak () os(kt)+bk () sin(kt))
(t) = nlim k

where  and  are random, time dependent fun -

(7)
=0

tions.
The volatility matrix is dened as: The generalization to multivariate volatility is
straightforward. The Fourier oeÆ ients of

ij (t) := lim#  EI N (ui(t + ) ui(t))

1 t
ij (i; j = 1; : : : ; N ) are
0
 (2) (ij ) = limN !1 N  n0

(uj (t + ) uj (t)) i; j = 1; : : : ; N: ak
PN +1

as (dui )as k (duj ) + as (duj )as k (dui ) :
1
s n0 + +
(8)
= 2

where EI N [
℄ denotes the expe tation operator and Similar formulas hold for (4) and (6).
t

Nt is the  eld generated by the full observation

of the e onomi data until time t. The relation stru t Note again that this method allows us to re on-
between (t) and the model (1) is given by the volatility inside the interval [0; 2℄ if u(t)
is observed in onitnuous time. Observe that the
Fourier oeÆ ients for ross-volatilities are om-
puted through the oeÆ ients omputed for the sin-
XN
ij (t) = ik (t)jk (t): gle time series.
k =1

2
3 Related Literature omputing ross volatilities. To avoid them, inter-
polation or imputation methods are employed. In
Estimation of volatility for ontinuous time pro- the rst ase a time horizon is xed, the time axis is
esses is a diÆ ult task. split a ording to that horizon and inside ea h in-
The lassi al way to estimate the volatility is to terval the last observation is onsidered. This pro-
adapt the formula (2) to the data observed with edure gives us homogeneous and equally spa ed
the given frequen y without onsidering the limit. time series but it entails two main drawba ks: in
The quadrati variation estimated empiri ally in some intervals of time no observation is available,
this way provides an unbiased estimator in ase some observations are thrown away. Interpolation
of onstant volatility. Many estimators have been requires to aggregate data observaions, entering
proposed in this setting. them at some points.
The literature on the estimation of volatility has Re ently new methods have been developed
grown up re ently for three main reasons: a) ti k whi h are not based on interpolation and imputa-
by ti k time series are now available, b) risk man- tion, see [10, 6℄. They avoid manipulation of the
agement te hniques, su h as VAR, based on the data by assuming that the returns are serially un-
estimation of the volatility are now heavily used orrelated (in the rst ase) and that the pro ess
in many nan ial institutions, ) the volatility for generating the transa tion times and the pri es are
nan ial time series is not onstant and in many independent (in the rst and in the se ond ase).
ases nonstationary. Our method does not make these assumptions.
The referen e framework foresees a parametriza- The literature on ti k by ti k observations pro-
tion of the volatility through onstant oeÆ ients vided us with some well established regularities. In
and then an estimator is employed. In this set- [7, 11℄ it is observed that ross volatilities tend to
ting unbiased estimators of the volatility have been vanish as the interval of time goes to zero, the so
proposed by simply onsidering the quadrati vari- alled Epps ee t. In some other papers it is ob-
ation of the nan ial data and using losing data served that returns omputed for a short interval
for se urities pri es, more rened estimators have of time are positively orrelated.
been proposed by onsidering high&low pri es, on
this point see for example [4℄. Model-free estimates
of volatilities have been proposed re ently. Among 4 Implementation
them we re all [3℄. The three reasons pointed out Applying the method to real data, we have at our
above motivated re ent developments in the litera- disposal a time series (ti ; S (ti)), i = 1; : : : K of N
ture. observations at time ti. In what follows we will take
First of all, nan ial time series analysis has S (t) as an asset pri e and u(t) = log S (t).
shown undoubtly that volatility is not onstant. We will ompress the data in the interval [0; 2℄
This on lusion is rea hed by onsidering time se- and ompute the integrals (3) through integration
ries with dierent frequen ies, see [14℄ for monthly by parts:
volatility. In parti ular it is observed a lustering R 
of volatility wi h also appears to be highly per- ak (du) =  1
os(kt)du(t) =
2

sistent. To model these phenomena, GARCH and = u   u k R  sin(kt)u(t)dt: (9)

0
(2 ) (0) 2

ARCH models have been proposed with auxialiary 0

As the observations are nite, to implement the

pro esses modeling the evolution of volatility. In- method and in parti ular the integration we need
traday patterns for volatility has been dete ted in an assumption on how data are onne ted. Our
many papers, see [1, ?℄. hoi e is u(t) be equal to u(ti) in the interval
Ti k by ti k observations of a time series pose [ti; ti ℄ (pie ewise onstant). With this hoi e, the
problems for the omputation volatility and in par- +1
integral in equation (9) in the interval [ti ; ti ℄ be-
ti ular of ross volatilities, see [9, 8℄ for a survey on omes:
+1

the analysis of this type of time series. Two time R

series reporting every pri e of the transa tions for k t +1
 t
i
sin(kt)u(t)dt = u(ti) k R
tt +1 sin(kt)dt =
i

two assets are hara terized by inequally and irreg- = u(ti)  os(kti ) os(kti )
i i
1
+1
ularly spa ed data, this fa t leads to problems in (10)

3
thus avoiding the multipli ation by k whi h ampli-
es an ellation errors when k be omes large.
The smallest wavelength that an be evaluated
is twi e the smallest distan e between two onse -
utive pri es; in the ase of equally spa ed data, it
will orrespond to k = N=2 (Nyquist frequen y),
see [13℄. We will always hoose N=2 as the largest
frequen y. Then the Fourier oeÆ ients (4),(5),(6)
will be evaluated for 0  k  J and with n = M
su h that:
M +J = (11)
N
2:
Sin e some tests showed that the results are in-
dipendent from the hoi e of n , we will hoose
0
n = 1.
0
In the integration by parts formula (9), the Figure 1: Moments of ak for N = 100,  = 0:01: for
1  k  50 (a) Mean k , it is onsistent with zero; (b)
onstant term (u(2) u(0))=2 appears in every Varian e k ; it is onsistent with =p
ak ; this ould make the formulas (9) too strongly
dependent from su h a random term so we add
to du the drift term u   u dt, so that the
(2 ) (0)

transformed u will have u(2) = u(0). Adding a

2

drift term to du, the volatility will not hange. 5.1  (t) = onstant

If  is onstant, then, as an be readily obtained:

ak ; bk  N (0; p ); k1

5 Monte Carlo Analysis 

We start with a single diusion pro ess, whi h in This distribution is the theoreti al one, but sin e
the following will represent the pri e of an asset. we take u(t) on a dis rete latti e and make as-
To simplify the analysis, we assume no drift and sumptions on how u(t) is onne ted between two
therefore we simulate the pri e model adjoining points, then su h distributions ould have
dS (t) =  (t)S (t)dW (t) t 2 [0; 2 ℄ a broader varian e.
To test this point, we perform the Fourier analy-
in the following way: sis on 500 Monte Carlo series of N data, results
are shown in gure 1 for N = 100. The result is
quite good: the varian e is the expe ted one and
8
= 100 the mean is onsistent with zero.
< S1
Si+1 = Si
eri
(12) We remark that takingqN data with a volatility 
:
ri  N (0; i ) means to take i =  N when drawing random
2

numbers in (12).
where with N (; ) we mean the normal distribu- We an now al ulate the moments of the -
tion of mean  and standard deviation . oeÆ ients. We know that:
We take u(t) = log S (t), therefore u(t) will follow
the sto hasti path: I [ak (du); bk (du)℄ = k
E
2 2 2

 (t)
2
V ar[ak (du); bk (du)℄ = 2k :
du(t) =
2 dt + (t)dW (t)
2 2 4

Starting from these equation, we get

so that it will have the same volatility as dS . We
an now make a test with dierent hoi es of (t). I [a ()℄ = 
E 0
2
(13)

4
 With this hoi e we want to he k if the algorithm
an reveal volatility variations inside the time win-
dow.
In a perfe t world s enario we should have
 r 
 + 2 2
ak (du); bk (du)  N 0;
2 : (18)
1 2

As before, we nd
r
 + 2 2
k = 1 2
(19)
2 :
The p formulas (13),(14),(16) remain the same with
 = ( +  )=2. It is enough to draw a on lu-
2 2

sion. Indeed, in order to reprodu e (t) as in (17)

1 2

Figure 2: Dots: varian e if the distribution obtained

on the MC sample for dierent hoi es of N.p Line: ex- we should have:
pe ted varian e as a fun tion of N:
= = 2=N ; it ak () = 0
gives the orre t explanation of the observed fun tion bk () = 1
k
(  )(( 1)k 1) (20)
2
2
2
1

so that the largest oeÆ ient is b =  (  ). 1

2 2 2

But the varian e of b (16) is of the same order of

2 1
1
magnitude or even larger than its expe ted mean.
4
[ ()℄ = 2 N :
V ar a0 (14)
For example, if we have  = 0:01;  = 0:03,
To estimate the moments of ak () and bk (), we 1
whi h is an unusual ase be ause a tually the dif-
2

will assume the oeÆ ients ak (du),bk (du) be in- feren e in a time window will be even smaller, we
dipendent, whi h is true if  is onstant but should have from (16) a standard deviation of 6
10 , 4

be he ked in any other ase. Making this assump- and from (20) an expe ted value of 6:34
10 . For 4

tion we readily obtain: larger k, the estimate of bk will be even poorer.

I [ak (); bk ()℄ = 0 (15) This makes us understand that it is nearly impos-
E
sible to re onstru t (t) for any t, sin e from a
[ (); bk ()℄ = 8 N :
4
(16) unique realization of the market there is no hope
V ar ak
to obtain the Fourier oeÆ ients with the needed
To he k the validity of su h formulas one an use pre ision. This fa t is illustrated in gure 3, where
again Monte Carlo experiments. So we an see ve dierent re onstru tions of the same generated
that the oeÆ ients of  are again gaussian vari- Monte Carlo sequen e are shown.
ables, with the rst two moments following formu-
las (13),(14),(15) and (16). Eventually, using the
above results we an give an estimate of the pre i-
5.3 Multivariate analysis

sion of the algorithm. We remark that if you are To test if the method works well in a multi-variate
interested only in the mean volatility of the interval analysis we generate two Monte Carlo pro ess with
hosen, then we have
p p<  >t = a , whi h will give a given degree of orrelation . This is easily done
in the following way: we hoose two random num-
0
a pre ision of ' 2= N , equal to the pre ision of
the lassi al ase (gure 2). bers,  and  with distribution N (0; ) and then
1 2
we transform them as
 (t) r =
5.2 = pie ewise onstant 1 p
r =  + 1   :
1
(21)
In the following we will hoose 2 2
2
1

 (t) =

 0t As an be easily he ked, r and r are still nor-
(17) mally 1 2
distributed with orrelation .
1
  < t  2
2

5
  is: r

 = (1  ) N1
2
(22)
where N is the number of data used.
5.4 Con lusions

From the above analysis, we have that given a time

window, we an ompute the mean of  on su h an
interval with the same pre ision as the varian e of
returns, and this is done through:
p
<>=a 0 (23)
with: r
Figure 3: Four dierent volatility re onstru tions; the
ii = 2 (24)
generated one is the bold line. The algorithm is unable ii N
to re onstru t the volatility inside the interval where N is the number of data used, and the error
on orrelations is given by formula (22).

6 Results on real data

We applied the method to a time series of daily
data of two indexes: Dow Jones Industrial and Dow
Jones Transportation from 1896 ro 1998 (28000
data). We divided this sample into 28 periods of
1000 data. The result is shown in gure 5; the
omparison looks very good.
7 High Frequen y Calibration
When we go in the high frequen y regime, we en-
ounter the diÆ ulty that the time intervals are not
equally spa ed. However, the Fourier algorithm,
Figure 4: Distibution of measured orrelation with being based on an integration pro edure instead of
the Fourier algorithm on three Monte Carlo simu-
lations with generated orrelation 0:5; 0:5; 0 (N =
a dierentiation one, should provide the ne essary
100). robustness to address this point. We will show this
is true.
An other problem that one has to fa e when try-
ing to perform a multivariate analysis on high fre-
quen y data, is that they are not syn hronous, e.g.
the pri e of two sto ks hanges at dierent times.
Then we test the algorithm on the Monte Carlo Again, we will resort to Monte Carlo analysis to
series, and the result is shown in gure 4 for  = provide more insight on the Fourier method. In
0:; 0:5; 0:5. The distribution is the same as the this ase one has to be areful, be ause hoosing
one expe ted from the lassi al way of estimating the Monte Carlo model means having in mind the
the orrelation, as in the univariate ase. A reason- market model, and results might be in uen ed by
able approximation of the error on the estimate of su h a hoi e.

6
 Figure 6: (a) Dots: Mean of the re onstru ted volatil-
ity distribution obtained for dierent values of N ; the
dashed line is the generated . (b) Dots: Varian e of
the distribution obtained for dierent Np. Dashed line:
the varian e in formula (24),
= = 2=N . Solid
Figure 5: Volatility Matrix for two indexes: Dow line: the varian e in (24) times p2; it approximately
Jones Industrial and Dow Jones Transportation. The explains the observed varian e.
agreement is perfe t. The volatility peak orresponds
to the Big Depression period.

We will hoose the following approa h to mimi

high frequen y data: at rst we will hoose a time
s ale orresponding to the smallest time interval
between trades (one se ond), then reprodu e the
Monte Carlo model with the method depi ted in
equation (21) using as the xed time interval su h
a time s ale; then we will hoose the trade times
randomly from an exponential distribution with a
given de ay time  (say 5 se onds).
Figure 6 shows the results obtained on the Monte
Carlo simulation of high frequen y data; for dier-
ent hoi es of N , mean and varian e of the obtained
distributions are shown. The mean is somewhat un- Figure 7: Syn ronization ee t: the solid urve is
derestimated of a few per ents, expe ially pwhen N the measured orrelation distribution when taking all
is small. The varian e is larger of a fa tor 2 than data; the dashed urve when taking only syn ronized
the previous ase, while no dipenden e on  has data. The widening of su h a distribution is due to
the loss in statisti s.
been observed, as expe ted. This extra-varian e
an be explained by looking at formula (10). In-
deed:
os(kti) os(kti ) =+1
an extra sour e of in ertitude, whi h results in an
= 2 sin k(ti +2 ti ) sin k(ti 2 ti )
+1 +1 extra-varian e.
The syn ronization ee t an be shown in gure
If ti ti is not a onstant, the se ond sine gives
+1 7. We generate two high frequen y series with or-

7
relation oeÆ ient 0:5 and  = 5. If we apply the General Ele tri s Al oa
Fourier algorithm using all the data at our disposal J.P. Morgan Co a-Cola
to ompute the integrals, we get the solid urve: it Merril Lyn h Mobil
exhibits positive orrelation but it is less than the Exxon Mer ks
generated one. If we apply Fourier analysis only Pepsi AT & T
to data points whi h o urr at the same time, we Table 1: The ten sto ks traded at NYSE used in this
get the dashed urve, whi h has the right orre- analysis in the month of January 1995
lation (but with a larger varian e due to loss in
statisti s). A ertain degree of orrelation has been
"lost" using not-syn ronous data.
This means that when re koning orrelations,
only that data whi h ome in the same time are
meaningful, not syn ronous data points annot
fully reveal orrelations. This is a serious limita-
tion, sin e the data set is redu ed by a fa tor  ,
the mean time between transitions; however the
fa t that the high frequen y data are not equally
spa ed does not ae t the power of the algorithm.
We phave to remark that also for orrelations an ex-
tra 2 term appears in the varian e (22).
7.1 Con lusions

Also for high frequen y data, given a time window,

we an ompute the mean of  on su h an interval
omputing a , with the pre ision
0 Figure 8: Cumulative distributions of the orrelations
r between the 10 sto ks in 84 time windows. The orre-

ii = 2 p2 (25)
lations are not e onomi ally signi ant.
ii N
where N is the number of data used, and the error
on orrelationspis reasonably given by formula (22)
multiplied by 2. Fourier Analysis the ross orrelations between the
10 sto ks. The distribution of su h orrelations is
shown in gure 8. Correlations are very lose to
zero when the frequen y is very high. It is a fa t
8 Results on real data well known in literature: when time goes to zero
orrelations go to zero too (Epps ee t) [7℄. We
We applied the method to time series of high fre- onrm this result.
quen y data registered at the New York Sto k Ex- We also employed the Fourier method to om-
hange for ten sto ks in the month of January, 1995. pute the auto orrelation oeÆ ient of every sto ks.
The sto ks are listed in table 1. 1
Figure 9 shows the result for J.P. Morgan on Jan-
We divided any trading day into 4 periods, any- uary 3th, tted with an exponential of de ay time 5
one 5800 se onds long. We used as the e onomi minutes. Table 8 shows the auto orrelation de ay
data the pri e of any transa tion and the mean of time obtained for the other sto ks in the same day.
bid pri e and ask pri e for any quote. The average They agree with the ones already observed in nan-
number of data in any day is shown in table 8. ial literature, onrming a positive auto orrelation
Within ea h of su h periods, for all the 21 trad- fun tion in the rst 5 10 minutes. Moreover we
ing days in the month, we omputed with the an observe that the auto orrelation fun tion re-
1 We wish to a knowledge INFM for providing this data mains positive for a longer time when the sto ks
set. are less liquid (less transa tions).

8
 Figure 9: Auto orrelation fun tion of J.P. Morgan on Figure 10: Upper gure: orrelation between Exxon
January 3th , 1995. It is well tted with an exponential and Mobil (lagged) on January 3th , 1995. It is sig-
with de ay time ' 5 minutes. ni antly positive in the rst minutes. Lower gure:
orrelation between Mobil and Exxon (lagged). No
signi ant orrelation appears.
Sto ks De ay time (min) Number of trades
Al oa 14:4  0:2 1130
Gen. Ele tri s 1:5  0:2 2467
J.P. Morgan 5:0  0:2 1369 taking the varian e of the distribution of returns.
Co a-Cola
Merril Lyn h
7:8  1:0
13  0:7
1407
732
The method presented here, being based on Fourier
Mobil 7:2  0:2 1255 analysis of the time series, exploits integration. We
Mer ks 1:2  0:2 1922 showed that the Fourier method is equivalent to
Pepsi 5:8  0:2 1326 the lassi al one when the time interval between
AT & T
Exxon
6  0:2
0:85  0:05
1717
1416
e onomi data is onstant, e.g. daily pri es. When
dealing with high frequen y data, where the time it-
Table 2: De ay time of the auto orrelation oeÆ- self be omes an important feature of the e onomi
ients of the ten sto ks onsidered pro ess, the Fourier methods provides the ne es-
sary stability and robustness, without resorting to
data manipulation.
Also lagged orrelations between sto ks an be Some results on real data have been shown, on-
measured with this times. Figure 10 shows su h rming some well estabilished results (the Epps ef-
a lagged orrelation between Exxon and Mobil on fe t, and the positive auto orrelation fun tion for
January 3th 1995. The bump in the upper gure be- a few minutes) whi h show the apability of the
tween 50 se onds shows that that day Exxon pri e method, whi h is substantially model-free, to in-
hanges in uen ed Mobil pri e hanges with a de- terpret and des ribe data.
lay of about 1 minute. The opposit is not true, as
seen in the lower gure. Referen es
[1℄ Andersen, T. Bollerslev, (1998) Deuts he
9 Con lusions Mark-Dollar Volatility: Intraday A tivity Pat-
terns, Ma roe onomi Announ ements, and
In this paper we analyzed a new methodology, de- Longer Run Dependen ies. Journal of Fi-
veloped in its mathemati al details in [12℄, to om- nan e, 53: 219-265.
pute histori al volatilities and orrelations. Clas-
si al methods rely on dierentiation, for example [2℄ Andersen, T. Bollerslev, (1997) Heterogee-

9
 nous Information Arrivals and Return Volatil- Market evolution, Dimadefas, Firenze, De em-
ity Dynami s: Un overing the Long-Run in ber 1999, 99-12.
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