UK Accounting Glossary
Volatility can refer to any basic process that complements a trigger mechanism.
In financial economics, volatility is a quantification of risk based on the standard deviation of an asset’s historical return.
To fix ideas, imagine that over the relevant period, a given asset has never returned more than 20% in a financial quarter on any dollar invested. Over the same period, the worst performance is a loss of 5% of the dollar.
In such a situation, a full plot of the returns by quarter would generally take the shape of the famous bell curve, or normal distribution. The 20% gain would be one “tail” of that curve. The 5% loss would be the other tail. Given an unskewed curve, 7.5% gain would be the mean asset return.
The “standard deviation” measures the width of the central hump of such a bell curve. That is also called the “volatility” of that asset because by definition the higher the number, the more wildly results may vary from quarter to quarter.
The volatility of an asset is crucial in the determination of the value of any future claim upon that asset.
In finance, volatility is a statistical measure of the tendency of a security’s price to change over time. Volatility is defined as the standard deviation of the return over time T. (For technical reasons, volatility is usually computed based on log return rather than return.) Volatility must be stated for a specific period of time, such as a day or a year. Implied volatility is the volatility suggested for the price of an underlying asset based on the price of an option on that underlying. Implied volatility is obtained by solving an option pricing formula such as Black-Scholes for the volatility variable using the current option price. Ordinarily, an option pricing model is used to price an option, using historical volatility. Thus a difference between implied volatility and historical volatility suggests that market participants believe a security’s performance will be different from past performance.
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This glossary post was last updated: 5th February 2020.