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EWMA Tutorial

After receiving several inquiries about the exponential weighted moving average (EWMA) function in NumXL, we decided to dedicate this issue to exploring this simple function in greater depth. The main objective of EWMA is to estimate the next-day (or period) volatility of a time series and closely track the volatility as it changes. For more information or related material, visit us at: http://www.spiderfinancial.com/products/numxl

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NumXL Pro
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PDF, TXT or read online on Scribd
241 views

EWMA Tutorial

After receiving several inquiries about the exponential weighted moving average (EWMA) function in NumXL, we decided to dedicate this issue to exploring this simple function in greater depth. The main objective of EWMA is to estimate the next-day (or period) volatility of a time series and closely track the volatility as it changes. For more information or related material, visit us at: http://www.spiderfinancial.com/products/numxl

Uploaded by

NumXL Pro
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PDF, TXT or read online on Scribd
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EWMATutorial 1 SpiderFinancialCorp,2013

Afterreceivingseveralinquiriesabouttheexponentialweightedmovingaverage(EWMA)functionin
NumXL,wedecidedtodedicatethisissuetoexploringthissimplefunctioningreaterdepth.
ThemainobjectiveofEWMAistoestimatethenextday(orperiod)volatilityofatimeseriesandclosely
trackthevolatilityasitchanges.
Background
Define
n
o asthevolatilityofamarketvariableondayn,asestimatedattheendofday 1 n .The
variancerateisThesquareofvolatility,
2
n
o ,ondayn.
Supposethevalueofthemarketvariableattheendofday i is
i
S .Thecontinuouslycompoundedrate
ofreturnduringdayI(betweenendofpriorday(i.e. 1 i )andendofday i )isexpressedas:
1
ln
i
i
i
S
r
S

=
Next,usingthestandardapproachtoestimate
n
o fromhistoricaldata,wellusethemostrecentm
observationstocomputeanunbiasedestimatorofthevariance:
2
2 1
( )
1
m
n i
i
n
r r
m
o

=

=

Where r isthemeanof
i
r :
1
m
n i
i
r
r
m

=
=

Next,letsassume 0 r = andusethemaximumlikelihoodestimateofthevariancerate:

2
2 1
m
n i
i
n
r
m
o

=
=

EWMATutorial 2 SpiderFinancialCorp,2013

Sofar,wehaveappliedequalweightstoall
2
n i
r

,sothedefinitionaboveisoftenreferredtoasthe
equallyweightedvolatilityestimate.
Earlier,westatedourobjectivewastoestimatethecurrentlevelofvolatility
n
o ,soitmakessenseto
givehigherweightstorecentdatathantoolderones.Todoso,letsexpresstheweightedvariance
estimateasfollows:

2 2
1
m
n i n i
i
r o o

=
=


Where:
-
i
o istheamountofweightgiventoanobservationidaysago.
- 0
i
o >
-
1
1
m
i
i
o
=
=


So,togivehigherweighttorecentobservations,
1 i i
o o
+
>
Longrun average variance
Apossibleextensionoftheideaaboveistoassumethereisalongrunaveragevariance
L
V ,andthatit
shouldbegivensomeweight:
2 2
1
m
n L i n i
i
V r o o

=
= +


Where:
-
1
1
m
i
i
o
=
+ =


- 0
L
V >
ThemodelaboveisknownastheARCH(m)model,proposedbyEnglein1994.
2 2
1
m
n i n i
i
r o e o

=
= +


EWMA
EWMAisaspecialcaseoftheequationabove.Inthiscase,wemakeitsothattheweightsofvariable
i
o
decreaseexponentiallyaswemovebackthroughtime.

EWMATutorial 3 SpiderFinancialCorp,2013

2 1
1 1
....
n
i i i i n
o o o o
+
+
= = = =
Unliketheearlierpresentation,theEWMAincludesallpriorobservations,butwithexponentially
decliningweightsthroughouttime.
Next,weapplythesumofweightssuchthattheyequaltheunityconstraint:

1
1 0
1
i
i
i i
o o

= =
= =


For 1 < ,thevalueof
1
1 o =
Nowweplugthosetermsbackintotheequation.Forthe
2
1 n
o

estimate:

1
2 2 2 2 3 2
1 1 1 2 1 3 1 1
1
2 2 2 3 2
1 2 3 1
...
(1 )( ... )
n
n
n i n i n n
i
n
n n n
r r r r
r r r
o o o o o
o


= = + + +
= + + +


Andthe
2
n
o estimatecanbeexpressedasfollows:
2 2 2 2 2
1 2 1
2 2 2 2 3 2
1 2 3 1
2 2 2
1 1
(1 )( ... )
(1 ) (1 )( ... )
(1 )
n
n n n
n
n n n n
n n n
r r r
r r r r
r
o
o
o o



= + + +
= + + + +
= +

Now,tounderstandtheequationbetter:

2 2 2
1 1
2 2 2 2
1 2 2
2 2 2 2 2 3 2
1 2 3 3
2 2 2 2 2 1 2 2 2
1 2 3
(1 )
(1 ) ((1 ) )
(1 ) (1 ) (1 )
(1 )( ... )
n n n
n n n n
n n n n n
m m
n n n n n m n m
r
r r
r r r
r r r r
o o
o o
o o
o o



+ +

= +
= + +
= + + +
= + + + + +

Foralargerdataset,the
2 2 m
n m
o
+

issufficientlysmalltobeignoredfromtheequation.
TheEWMAapproachhasoneattractivefeature:itrequiresrelativelylittlestoreddata.Toupdateour
estimateatanypoint,weonlyneedapriorestimateofthevariancerateandthemostrecent
observationvalue.
AsecondaryobjectiveofEWMAistotrackchangesinthevolatility.Forsmall values,recent
observationsaffecttheestimatepromptly.For valuesclosertoone,theestimatechangesslowly
basedonrecentchangesinthereturnsoftheunderlyingvariable.

EWMATutorial 4 SpiderFinancialCorp,2013

TheRiskMetricsdatabase(producedbyJPMorganandmadepublicavailable)usestheEWMAwith
0.94 = forupdatingdailyvolatility.
IMPORTANT:TheEWMAformuladoesassumealongrunaveragevariancelevel.Thus,theconceptof
volatilitymeanreversionisnotcapturedbytheEWMA.TheARCH/GARCHmodelsarebettersuitedfor
thispurpose.
Lambda ()
AsecondaryobjectiveofEWMAistotrackchangesinthevolatility,soforsmall values,recent
observationaffecttheestimatepromptly,andfor valuesclosertoone,theestimatechangesslowlyto
recentchangesinthereturnsoftheunderlyingvariable.
TheRiskMetricsdatabase(producedbyJPMorgan)andmadepublicavailablein1994,usestheEWMA
modelwith 0.94 = forupdatingdailyvolatilityestimate.Thecompanyfoundthatacrossarangeof
marketvariables,thisvalueof givesforecastofthevariancethatcomeclosesttorealizedvariance
rate.Therealizedvarianceratesonaparticulardaywascalculatedasanequallyweightedaverageof
2
i
r
onthesubsequent25days.

24
2
2 0
25
n i
i
n
r
o
+
=
=

Similarly,tocomputetheoptimalvalueoflambdaforourdataset,weneedtocalculatetherealized
volatilityateachpoint.Thereareseveralmethods,sopickone.Next,calculatethesumofsquared
errors(SSE)betweenEWMAestimateandrealizedvolatility.Finally,minimizetheSSEbyvaryingthe
lambdavalue.
Soundssimple?Itis.Thebiggestchallengeistoagreeonanalgorithmtocomputerealizedvolatility.For
instance,thefolksatRiskMetricschosethesubsequent25daytocomputerealizedvariancerate.In
yourcase,youmaychooseanalgorithmthatutilizesDailyVolume,HI/LOand/orOPENCLOSEprices.
FAQ
Q1:CanweuseEWMAtoestimate(orforecast)volatilitymorethanonestepahead?
TheEWMAvolatilityrepresentationdoesnotassumealongrunaveragevolatility,andthus,forany
forecasthorizonbeyondonestep,theEWMAreturnsaconstantvalue:

2 2 2
1 1
2 2 2 2 2 2
1
2 2
(1 )
[ ] [(1 ) ] (1 ) [ ]
[ ]
n n n
n n n n n n
n m n
r
E E r E r
E
o o
o o o o
o o

+
+
= +
= + = + =
=

EWMATutorial 5 SpiderFinancialCorp,2013

Q2:Whatistheinitialvalueofthevariance(i.e.
2
1
o )intheNumXLEWMAfunction?CanIseta
differentvalue?
Currently,wesetthevaluetozero,butwesetthevarianceattheendoffirstperiodequaltothesquare
ofreturnonthatperiodtostarttheEWMA.

2
0
2 2
1 1
2 2 2 2
2 1 1 1
2 2 2
3 2 2
2 2 2
1 1
0
(1 )
(1 )
...
(1 )
n n n
r
r r
r
r
o
o
o o
o o
o o

=
=
= + =
= +
= +

Foralargedataset,thevaluehasverylittleimpactonthecalculatedvalue.
Goingforward,weareplanningtoavailanargumenttoacceptuserdefinedinitialvolatilityvalue.
Q3:WhatisEWMAsrelationshiptoARCH/GARCHModel?
EWMAisbasicallyaspecialformofanARCH()model,withthefollowingcharacteristics:
1. TheARCHorderisequaltothesampledatasize.
2. Theweightsareexponentiallydecliningatrate throughouttime.
Q4:DoesEWMAreverttothemean?
NO.EWMAdoesnothaveatermforthelongrunvarianceaverage;thus,itdoesnotreverttoanyvalue.
Q5Whatisthevarianceestimateforhorizonbeyondoneday(orstep)ahead?
AsinQ1,theEWMAfunctionreturnsaconstantvalueequaltotheonestepestimatevalue.
Q6Ihaveweekly/monthly/annualdata.Whichvalueof Ishoulduse?
Youmaystilluse0.94asadefaultvalue,butifyouwishtofindtheoptimalvalue,youdneedtosetup
anoptimizationproblemforminimizingtheSSEorMSEbetweenEWMAandrealizedvolatility.
Seeourvolatility101tutorialinTipsandHintsonourwebsiteformoredetailsandexamples.
Q7:ifmydatadoesnothaveazeromean,howcanIusethefunction?

EWMATutorial 6 SpiderFinancialCorp,2013

Fornow,usetheDETRENDfunctiontoremovethemeanfromthedatabeforeyoupassittotheEWMA
functions.
InfutureNumXLreleases,theEWMAwillremovethemeanautomaticallyonyourbehalf.

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