Chapter 2: FAQs 153
and demand. Is that the same as the market taking
a view on future volatility? Not necessarily because
most people buying options are taking a directional
view on the market and so supply and demand reflects
direction rather than volatility. But because people who
hedge options are not exposed to direction only volatil-
ity it looks to them as if people are taking a view on
volatility when they are more probably taking a view
on direction, or simply buying out-of-the-money puts
as insurance against a crash. For example, the market
falls, people panic, they buy puts, the price of puts
and hence implied volatility goes up. Where the price
stops depends on supply and demand, not on anyone’s
estimate of future volatility, within reason.
Implied volatility levels the playing field so you can
compare and contrast option prices across strikes and
expirations.
There is alsoforward volatility. The adjective ‘forward’ is
added to anything financial to mean values in the future.
So forward volatility would usually mean volatility, either
actual or implied, over some time period in the future.
Finallyhedging volatilitymeans the parameter that you
plug into a delta calculation to tell you how many of the
underlying to sell short for hedging purposes.
Since volatility is so difficult to pin down it is a natural
quantity for some interesting modelling. Here are some
of the approaches used to model or forecast volatility.
Econometric models: These models use various forms of
time series analysis to estimate current and future
expected actual volatility. They are typically based on
some regression of volatility against past returns and
they may involve autoregressive or moving-average com-
ponents. In this category are theGARCHtype of mod-
els. Sometimes one models the square of volatility, the