# Clustering of volatility as a multiscale phenomenon

## I Introduction

One of the most challenging problem in finance is the stochastic characterization of market returns. This topic not only has an academic relevance but it also has an obvious technical interest. Think, for example, at the option pricing models where distribution and correlations of volatility play a central role.

It is now well established that returns of the most important indices and foreign exchange markets have a distribution with fat tails, and that they are uncorrelated on lags larger than a single day, in agreement with the hypothesis of efficient market. On the contrary, the distribution of volatility and its correlations are still poorly understood. What it is known is that absolute returns (which are a measure of volatility) have memory on a long time range, this phenomenon is known in financial literature as clustering of volatility. Recent studies provide a strong evidence for power-law correlations for absolute returns . Notice that in ARCH-GARCH approach  volatility memory is longer than a single time step but it decays exponentially, which implies that ARCH-GARCH modeling is inappropriate. Indeed, GARCH models have been extended in order to take into account this long memory properties .

In this paper we analyze the daily returns of the the New York Stock Exchange (NYSE) composite index from January 1966 to June 1998, and the US Dollar/Deutsch Mark (USD-DM) noon buying rates certified by the Federal Reserve Bank of New York from October 1989 to September 1998. We not only find that volatility correlations are power-laws on long time scales up to a year for NYSE index and six months for USD-DM exchange rate, but, more important, that they exhibit a non-unique exponent (multiscaling). This kind of multiscale phenomenology is known to be relevant in fully developed turbulence and in disordered systems , and it is recently pointed out for a financial series . Our result is based on the fluctuation analysis of a new class of variable that we call generalized cumulative absolute returns.

The second main result of the paper is the study of volatility probability distribution, which is derived by means of Fourier transform analysis. It is shown that it is well approximated by a log-normal distribution for NYSE index, while a log-normal shape is a reasonable fit only around the maximum for USD-DM rate.

The paper is organized as follows: in section II we show that volatility has a long memory by considering the autocorrelation of absolute returns. Nevertheless the power-law behavior cannot be inferred by simply considering autocorrelations. In order to have a sharper evidence for the nature of the long memory phenomenon, in section III, we perform a scaling analysis on the standard deviation of a new class of observables, the generalized cumulative absolute returns. This analysis implies power-law correlations with non-unique exponent. In section IV the attention is focused on volatility probability distribution, computed from returns data by means of Fourier transform analysis, which turns out to be log-normal at least for NYSE index. In section V some final remarks can be found.

## II Correlations for returns

We consider the New York Stock Exchange (NYSE) daily composite index closes (January 1966 to June 1998) and the US Dollar/Deutsch Mark (USD-DM) noon buying rates certified by the Federal Reserve Bank of New York (October 1989 to September 1998). In the first case the dataset contains $`8180`$ quotes, in the second $`2264`$. The quantity we consider is the (de-trended) daily return, defined as

$$r_t=\mathrm{log}\frac{S_{t+1}}{S_t}\mathrm{log}\frac{S_{t+1}}{S_t}$$
(1)   
where $`S_t`$ is the index quote or the exchange quote at time $`t`$. The time $`t`$ ranges from 1 to $`N`$ where N is the total number of quotes ($`8180`$ for the NYSE index and $`2264`$ for the USD-DM exchange rate). The notation $``$ indicates the average over the whole sequence of $`N`$ data.

As pointed out by several authors , the distribution of returns is leptokurtic. In , it was firstly proposed a symmetric Lévy stable distribution and more recently in  it is argued that the distribution is Lévy stable except for tails, which are approximately exponential. The estimation is that the shape of a Gaussian is recovered only on longer scales, typically for monthly returns.

Let us introduce the autocorrelation for returns, defined as

$$C(L)=r_tr_{t+L}r_tr_{t+L}.$$
(2)   
A direct numerical analysis of (2) for the NYSE index (fig. 1a) and for USD-DM rate (fig. 1b) shows that returns autocorrelation is a vanishing quantity for all $`L`$. This simple evidence could induce to the wrong conclusion that description is complete, i.e. returns are i.i.d. variables whose distribution is a truncated Levy. The situation is much more complicated, in fact, even if returns autocorrelation vanishes, one cannot conclude that returns are independent variables. Independence implies that all functions of returns are uncorrelated variables. This is known to be false, in fact volatility have a long memory. On the other hand, the daily volatility is not directly observable, and informations about it can be derived by means of absolute returns $`\left|r_t\right|`$.

It is useful to consider the following autocorrelation for powers of absolute returns

$$C(L,\gamma )=\left|r_t\right|^\gamma \left|r_{t+L}\right|^\gamma \left|r_t\right|^\gamma \left|r_{t+L}\right|^\gamma .$$
(3)   
This quantity is plotted for $`\gamma =1`$ in fig. 1a (NYSE index) and in fig. 1b (USD-DM exchange rate). Unlike returns autocorrelation, it turns out to be a non vanishing quantity, at least up to $`L150`$ (see  and the references therein). This is a clear evidence that it is not correct to assume returns as independent random variables.

On the other hand, figs. 1 cannot give a satisfactory answer about the shape of absolute returns autocorrelations. In fact, data show a wide spread compatible with different scaling hypothesis. In figs. 1 we have reported two power-law functions with exponents derived by scaling analysis, which will be performed in the next section. The proposed interpolations are consistent with numerical data.

## III Scaling analysis

In the previous section we have seen that, consistently with the efficient market hypothesis, daily returns have no autocorrelations on lags larger than a single day. This fact can be also checked by using of scaling analysis. Consider the cumulative returns $`\varphi _t(L)`$, defined as the sum of $`L`$ successive returns $`r_t,\mathrm{},r_{t+L1}`$, divided by $`L`$

$$\varphi _t(L)=\frac{1}{L}\underset{i=1}{\overset{L}{}}r_{t+i}=\frac{1}{L}\left[\mathrm{log}\frac{S_{t+L}}{S_t}\mathrm{log}\frac{S_{t+1}}{S_t}\right].$$
(4)   
One can define $`N/L`$ non overlapping variables of this type, and compute the associated variance $`Var\left(\varphi (L)\right)`$. Assuming that $`r_t`$ are uncorrelated (or short range correlated), it follows that $`Var\left(\varphi (L)\right)`$ has a power-law behavior with exponent $`\alpha =1`$ for large $`L`$ (see Appendix A), i.e.

$$Var\left(\varphi (L)\right)L^1.$$
(5)   
The exponent $`\alpha `$ both for the NYSE index and USD-DM exchange market turns out to be around 1 (see figs. 2 and also see ), confirming that returns are uncorrelated.

On the contrary, this is not true for other quantities related to absolute returns. In order to perform the appropriate scaling analysis, let us introduce the generalized cumulative absolute returns defined as the sum of $`L`$ successive returns $`\left|r_t\right|^\gamma ,\mathrm{},\left|r_{t+L1}\right|^\gamma `$, divided by $`L`$

$$\varphi _t(L,\gamma )=\frac{1}{L}\underset{i=1}{\overset{L}{}}\left|r_{t+i}\right|^\gamma $$
(6)   
where $`\gamma `$ is a real exponent and, again, these quantities are not overlapping.

In appendix A we show that if the autocorrelation for powers of absolute returns (3) exhibits a power-law with exponent $`\alpha (\gamma )1`$ for large $`L`$, i.e. $`C(L,\gamma )L^{\alpha (\gamma )}`$, it would imply that

$$Var\left(\varphi (L,\gamma )\right)L^{\alpha (\gamma )}.$$
(7)   
On the contrary, if the $`\left|r_t\right|^\gamma `$ are short-range correlated or power-law correlated with an exponent $`\alpha (\gamma )>1`$, we would not detect anomalous scaling in the analysis of variance, i.e. $`Var\left(\varphi (L,\gamma )\right)L^1`$.

Our numerical analysis shows very sharply an anomalous power-law behaviour, after a very short transient time, in the range up to one year ($`L=250`$) for NYSE index (fig. 2a), and up to six months ($`L=150`$) for the USD-DM exchange market (fig. 2b). For larger $`L`$ the number of non overlapping variables $`\varphi (L,\gamma )`$ becomes too small for a statistical analysis, as revealed also by the increasing fluctuations on variance $`Var\left(\varphi (L,\gamma )\right)`$ as function of $`L`$. The best fit straight lines are performed in the range, respectively, $`10L250`$ for the NYSE index, and in the range $`10L150`$ for the USD-DM rate.

The crucial result is that $`\alpha (\gamma )`$ is not a constant function of $`\gamma `$, showing the presence of different anomalous scales. The interpretation is that different values of $`\gamma `$ select different typical fluctuation sizes, any of them being power-law correlated with a different exponent. The case $`\gamma =0`$ corresponds to cumulative logarithm of absolute returns. Approximately, in the region $`\gamma 4`$ the averages are dominated by only few events, corresponding to very large returns and, therefore, the statistics becomes insufficient.

In fig. 3, $`\alpha (\gamma )`$ is plotted as a function of $`\gamma `$ with error bars for both cases. In the NYSE index case, the exponent $`\alpha (\gamma )`$ exhibits a large spread, reaching an ordinary scaling exponent $`\alpha (\gamma )=1`$ for $`\gamma 4`$. On the contrary, the USD-DM exponent turns out to be less variable, rising slowly towards $`\alpha (\gamma )=1`$.

We would like to stress that the scaling analysis in figs. 2 definitively proves the power-law behaviour and precisely determine the coefficients $`\alpha (\gamma )`$, while a direct analysis of the autocorrelations (as in figs. 1) would not have provided an analogous clear evidence for multiscale power-law behaviour, since the data show a wide spread compatible with different scaling hypothesis.

The anomalous power-law scaling can be eventually tested against the plot of autocorrelations. For instance, the autocorrelations of $`r_t`$ and of $`|r_t|`$ are plotted in figs. 1 as a function of the correlation length $`L`$, and the full line, which is in a good agreement with the data, is not a best fit but it is a power-law whose exponent $`\alpha (1)`$ is obtained by the scaling analysis of the variance.

## IV Distribution of volatility

All the discussion in previous section concerns absolute returns. An obvious question is: ’what is the relation with volatility?’. The answer is not completely trivial, since from an operative point of view, the volatility is often assumed to coincide with the intra-day absolute cumulative return or, alternatively, with the implied volatility which can be extracted from option prices.

Our point of view is that the exact definition of volatility cannot be independent from the theoretical framework. It is usually assumed that the volatility $`\sigma _t`$ is defined by

$$r_t=\sigma _t\omega _t$$
(8)   
where the $`\omega _t`$ are identically distributed random variables with vanishing average and unitary variance. The usual choice for the distribution of the $`\omega _t`$ is the normal Gaussian. This picture is completed by assuming the probabilistic independence between $`\sigma _t`$ and $`\omega _t`$.

In other terms, the returns series can be considered as a realization of a random process based on a zero mean Gaussian, with a standard deviation $`\sigma _t`$ that changes at each time step. According to the above definition, all the scaling property we have found on absolute returns directly apply to volatility.

Volatility $`\sigma _t`$ is an hidden variable, since we can directly evaluate only daily returns. Nevertheless, in appendix B we show how to derive the volatility probability distribution $`p(\sigma )`$ starting from the returns series. The key point is to move the problem in the space of the characteristic functions (Fourier transforms).

The probability distribution $`p(\sigma )`$ is plotted in fig. 4, both for the NYSE index and the USD-DM exchange rate. The results corresponding to extreme values of volatility ($`\sigma 0`$ and $`\sigma 0.02`$) are not confident due to insufficient statistics.

The astonishing fact is that NYSE volatility distribution is well fitted by a log-normal distribution 

$$p(\sigma )=\frac{1}{\sqrt{2\pi }s\sigma }\mathrm{e}^{\frac{1}{2}\left(\frac{\mathrm{log}\sigma m}{s}\right)^2}.$$
(9)   
The fit is performed in the range $`0.0035\sigma 0.01`$ and gives $`m=4.94\pm 0.01`$ and $`s=0.44\pm 0.01`$, while the USD-DM volatility distribution is consistent with a log-normal distribution with $`m=5.27\pm 0.01`$ and $`s=0.54\pm 0.01`$ only in a narrow region around the maximum ($`0.0025\sigma 0.005`$).

This unexpected log-normal shape for the volatility distribution suggests the existence of some underling multiplicative process for volatility, at least for the NYSE index. This result implies that not only indices prices are multiplicative processes, but also the associated returns. On the other hand, the USD-DM rate analysis might be affect by insufficient statistics problems, which leads to an over-estimation of distribution tail in the range $`\sigma 0.01`$. Under this hypothesis, a log-normal shape could be consistent with the USD-DM volatility distribution, and an underling multiplicative process might be present also for foreign exchange returns.

A possible and reasonable tentative to explain this peculiar behaviour for the volatility distribution can be found in , where a multiplicative cascade process for volatility is proposed, borrowing well-known arguments from turbulence theory.

## V Conclusions

The first result we have found is that the scaling of variance of the generalized cumulative absolute returns is power-law with non-unique exponent, for both the NYSE daily index and the USD-DM exchange rate. This fact implies power-law correlations whose exponent depends on the variable which is considered. The main theoretical consequence is that models with exponential correlations, like ARCH-GARCH, fails in describing the dynamics of financial markets, and that new models should account for the coexistence of long memory with different scales.

The second result is that volatility distribution is log-normal, at least for NYSE index. This fact suggests that volatility itself evolves as a multiplicative process.

These two results show the existence of an underling process that drives daily returns, and indicates that new modelizations of financial markets have to look to returns as a subordinate process of volatility.

Acknowledgements

We thank Roberto Baviera, Rosario Mantegna and Angelo Vulpiani for many interesting conversations concerning data analysis and models for dynamics of prices.

## Appendix A

In this appendix we show that if the correlations $`C(L,\gamma )`$ exhibit a long range memory, $`C(L,\gamma )L^{\alpha (\gamma )}`$, then also the variance $`Var(\varphi (L,\gamma ))`$ of the generalized cumulative absolute returns behaves at large $`L`$ as $`L^{\alpha (\gamma )}`$.

The explicit expression of variance is

$$Var\left(\varphi (L,\gamma )\right)=\frac{1}{L^2}\underset{i=1}{\overset{L}{}}\underset{j=1}{\overset{L}{}}|r_{t+i}|^\gamma |r_{t+j}|^\gamma |r_{t+i}|^\gamma |r_{t+j}|^\gamma .$$

Taking into account that $`r_t`$ is a stationary process, and using the definition of $`C(L,\gamma )`$ (3), one has:

$$Var\left(\varphi (L,\gamma )\right)=\frac{1}{L}C(0,\gamma )+\frac{2}{L^2}\underset{Li>j1}{}C(ij,\gamma )$$

where

$$C(0,\gamma )=|r_t|^{2\gamma }|r_t|^\gamma ^2.$$

The previous expression can be rewritten as

$$Var\left(\varphi (L,\gamma )\right)=\frac{1}{L}C(0,\gamma )+\frac{2}{L^2}\underset{i=1}{\overset{L1}{}}(Li)C(i,\gamma ).$$

Under the hypothesis $`C(L,\gamma )L^{\alpha (\gamma )}`$, one has for large $`L`$

$$\frac{2}{L^2}\underset{i=1}{\overset{L1}{}}(Li)C(i,\gamma )L^{\alpha (\gamma )}$$

which leads to

$$Var\left(\varphi (L,\gamma )\right)=O(L^1)+O(L^{\alpha (\gamma )}).$$

For our data $`\alpha (\gamma )1`$, and then

$$Var\left(\varphi (L,\gamma )\right)L^{\alpha (\gamma )}.$$

On the contrary, if $`\alpha (\gamma )>1`$ or worst, correlations exhibit a faster decay, the variance $`Var(\varphi (L,\gamma ))`$ would be a power-law with scaling exponent equals to $`1`$.

A similar sketch can be repeated for the cumulative returns $`\varphi (L)`$. In this case since correlation has a fast decay, we have

$$Var\left(\varphi (L,\gamma )\right)L^1.$$

## Appendix B

Let us introduce the variables $`_t,𝒮_t,𝒲_t`$, defined as

$$\begin{array}{ccc}_t=\mathrm{log}|r_t|\hfill & & \\ 𝒮_t=\mathrm{log}\sigma _t\hfill & & \\ 𝒲_t=\mathrm{log}|\omega _t|\hfill & & \end{array}$$

which are related among them by virtue of (8) by

$$_t=𝒮_t+𝒲_t.$$

For the associated probability distributions (respectively $`Q(),P(𝒮),T(𝒲)`$) the following relation holds

$$Q()=_{\mathrm{}}^+\mathrm{}𝑑𝒮P(𝒮)T(𝒮).$$
(10)   
The distribution $`P(𝒮)`$ retains full information on the volatility probability distribution $`p(\sigma )`$, since $`p(\sigma )=P(\mathrm{log}\sigma )/\sigma `$.

In order to derive from (10) an explicit expression for $`P(𝒮)`$, it is convenient to consider the characteristic functions (Fourier transforms) $`\stackrel{~}{Q}(\stackrel{~}{}),\stackrel{~}{P}(\stackrel{~}{𝒮}),\stackrel{~}{T}(\stackrel{~}{𝒲})`$ of $`Q(),P(𝒮),T(𝒲)`$. In fact, the following simple relation holds

$$\stackrel{~}{Q}(\stackrel{~}{𝒮})=\stackrel{~}{P}(\stackrel{~}{𝒮})\stackrel{~}{T}(\stackrel{~}{𝒮})$$

and the inverse Fourier transform gives

$$P(𝒮)=\frac{1}{2\pi }_{\mathrm{}}^+\mathrm{}𝑑\stackrel{~}{𝒮}\frac{\stackrel{~}{Q}(\stackrel{~}{𝒮})}{\stackrel{~}{T}(\stackrel{~}{𝒮})}\mathrm{e}^{i𝒮\stackrel{~}{𝒮}}.$$

Notice that $`\stackrel{~}{Q}(\stackrel{~}{𝒮})`$ and $`\stackrel{~}{T}(\stackrel{~}{𝒮})`$ are complex objects, but we may consider only the real part of the integrand, since the result of the integration has to be real

$$P(𝒮)=\frac{1}{2\pi }_{\mathrm{}}^+\mathrm{}𝑑\stackrel{~}{𝒮}\mathrm{Re}\left[\frac{\stackrel{~}{Q}(\stackrel{~}{𝒮})}{\stackrel{~}{T}(\stackrel{~}{𝒮})}\mathrm{e}^{i𝒮\stackrel{~}{𝒮}}\right]$$
(11)   
where

$$\mathrm{Re}\left[\frac{\stackrel{~}{Q}(\stackrel{~}{𝒮})}{\stackrel{~}{T}(\stackrel{~}{𝒮})}\mathrm{e}^{i𝒮\stackrel{~}{𝒮}}\right]=\frac{\left(\mathrm{Re}\stackrel{~}{Q}\mathrm{Re}\stackrel{~}{T}+\mathrm{Im}\stackrel{~}{Q}\mathrm{Im}\stackrel{~}{T}\right)\mathrm{cos}(𝒮\stackrel{~}{𝒮})}{(\mathrm{Re}\stackrel{~}{T})^2+(\mathrm{Im}\stackrel{~}{T})^2}+$$

$$+\frac{\left(\mathrm{Re}\stackrel{~}{Q}\mathrm{Im}\stackrel{~}{T}\mathrm{Im}\stackrel{~}{Q}\mathrm{Re}\stackrel{~}{T}\right)\mathrm{sin}(𝒮\stackrel{~}{𝒮})}{(\mathrm{Re}\stackrel{~}{T})^2+(\mathrm{Im}\stackrel{~}{T})^2}.$$

From a practical point of view, $`\mathrm{Re}\stackrel{~}{Q}(\stackrel{~}{𝒮})`$ and $`\mathrm{Im}\stackrel{~}{Q}(\stackrel{~}{𝒮})`$ can be directly computed from the returns series

$$\mathrm{Re}\stackrel{~}{Q}(\stackrel{~}{𝒮})=_{\mathrm{}}^+\mathrm{}𝑑Q()\mathrm{cos}(\stackrel{~}{𝒮})\frac{1}{N}\underset{t=1}{\overset{N}{}}\mathrm{cos}(\stackrel{~}{𝒮}_t)$$

$$\mathrm{Im}\stackrel{~}{Q}(\stackrel{~}{𝒮})=_{\mathrm{}}^+\mathrm{}𝑑Q()\mathrm{sin}(\stackrel{~}{𝒮})\frac{1}{N}\underset{t=1}{\overset{N}{}}\mathrm{sin}(\stackrel{~}{𝒮}_t).$$

The Fourier transforms $`\mathrm{Re}\stackrel{~}{T}(\stackrel{~}{𝒮})`$ and $`\mathrm{Im}\stackrel{~}{T}(\stackrel{~}{𝒮})`$ can be evaluated numerically starting from their definitions:

$$\mathrm{Re}\stackrel{~}{T}(\stackrel{~}{𝒮})=_{\mathrm{}}^+\mathrm{}𝑑T()\mathrm{cos}(\stackrel{~}{𝒮})$$

$$\mathrm{Im}\stackrel{~}{T}(\stackrel{~}{𝒮})=_{\mathrm{}}^+\mathrm{}𝑑T()\mathrm{sin}(\stackrel{~}{𝒮})$$

where

$$T()=\sqrt{\frac{2}{\pi }}\mathrm{e}^{\frac{1}{2}\mathrm{e}^2}.$$

Finally, the probability distribution $`P(𝒮)`$, and then $`p(\sigma )`$, can be computed via the numerical evaluation of integral (11).

The key step of this procedure is the numerical inverse Fourier transform, therefore the delicate point is the evaluation of the tails of the probability distribution $`P(𝒮)`$, where the limited number of data leads to spurious fluctuations.