The Epidemiology of Volatility Transmission: Part 2

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This is part 2 of a two-part series on how volatility transmission mimics the spread of infectious disease and how investors can use VIX-linked securities as either a left-tail risk hedge or a distinct, tradable asset class. Part 1 can be read here.

Model behavior and term structures

“Essentially, all models are wrong, but some are useful.” – George E. P. Box (1919 – 2013)

What is volatility? The word has a noble origin. The Latin volatilis has several meanings, included winged, flying, swift, and fleeting and is derived from the verb volare, to fly. In modern English, the word volatility is also concerned with movement, variation and risk. In science, an everyday word can be expropriated and given a very precise meaning. Finance is no different. The Black, Scholes and Merton options pricing model assigned a mathematical definition to stock market volatility. Since then, in the valuation world, volatility was often been defined as the standard deviation (the square root of variance) of the log of the changes in value (or price) over a specified time period.1

Volatility can be modeled. There are stylized facts about volatility that need be incorporated into a volatility model. Several of those facts are that volatility is persistent in the short-run, means-reverting over the long-run (it has a half-life) and it is asymmetrical.2 A practical, useful volatility model should be able to forecast volatility. The 1927 Kermack-McKendrick Epidemiology Model – detailed in part 1 of this series – is a helpful proxy giving insight into how market volatility is transmitted.