Why is volatility an important topic in financial econometrics?

Question

I do not know if it is totally off-topic, but I thought it might be useful to have opinions and an aggregate answer about why volatility is an important topic in financial econometrics.

I think it started with portfolio theory and the need to understand the properties of the underlying second moment of the asset returns. Subsequently the Black-Scholes formula and the popularity of derivatives made this entity very important in Finance.

Answer 1

Past volatility in the price of something is a measure of the inability of the past to predict the present, as otherwise prices would largely change smoothly just reflecting time costs, and so in many (but not all) cases it could be an indicator of how difficult it might be for the present to predict the future.

Hence it becomes an indicator of risk, and affects the values of derivatives: buying an option will tend to be more expensive if both parties believe prices are likely to be volatile in future and the option is more likely to be exercised.

Answer 2

I think the main reason is that many financial time series exhibit high volatility and the standard ARIMA models do not fit well to data with high volatility. So special time series models that account for this are important to generate better predictions.

The ARIMA models are well established while time series models such as GARCH that model volatility are newer and more open for extensions and theoretical development. These are reasons why this topic would be appealing to academics.

Answer 3

I'm not an economist, but my guesses would be that: 1) there are several options/futures-based techniques for profiting from high volatility, and 2) higher volatility corresponds to greater risk in some sense, or at least investor confidence/nervousness.

Answer 4

Modern Portfolio Theory (MPT) and the Efficient Market Hypothesis (EMH) share important assumptions. Amongst them is the assumption that all investors are at all times profit maximizing, rational and risk-averse. If this is the case then excess vol and vol clusters are said to violate a strict form of the EMH since this indicates that prices may deviate from fundamentals. Of course, excess vol/vol clusters are seen at all levels of granularity in financial time series.

Financial economists seek to explain why excess vol exists and how best to incorporate it in their models. While the ideas about how to model vol don't necessarily come from financial economists, important ones, like ARCH/GARCH did, and were subsequently incorporated by financial firms in their pricing models and trading strategies.