Documentation>Common Volatility Risk Analysis

Financial markets are difficult to predict accurately. Realized returns can be more extreme than predicted when important events trigger adjustments in forecasts across asset classes, sectors and countries. Such significant shocks could arise from geopolitical tensions, elections, policy changes, cyber or terrorist attacks, pandemics and climate change. Global common volatility (COVOL) is a statistical measure of the magnitude of such shocks that helps explain large unexpected financial outcomes and why they are often common to a wide range of financial asset prices. The global COVOL model of Engle and Campos-Martins (2023) is simple, the estimation and testing are easy to implement and can capture complex shocks with global impact that make financial asset prices worldwide move unexpectedly at the same time.

Hedging such risks has practical benefits to investors and firms as global financial risk is often the explanation for weak investment results. As investors look beyond their home market for the global investment opportunity set, it matters from where risk is coming in to where it spreads. However, risk arising from a global common event is potentially very dangerous to investors since a single event can result in increased volatility for all assets in a portfolio or all lines of business for a conglomerate firm. Conventional diversification does not reduce its impact. Markowitz style portfolios are predicted to have low volatility but they may be very sensitive to volatility shocks. Thus, assets that are not sensitive to volatility shocks are likely to be attractive in a portfolio because they diversify global common risk.

The common volatility risk analysis section of V-Lab attempts to provide a means of properly identifying and quantifying global COVOL, a broad measure of all types of global financial risk.

Common Volatility
𝔼 t-1 xt = 1 , 𝔼 t-1 xt-1 2 = vt , xt > 0 , s 01 e it = g si xt ε it , g = si xt + 1 - si L ( s , x ; e ) = -0.5 i = 1 , t = 1 N , T log g si xt + e i,t 2 g si xt