Classical volatility estimator may become unreliable, says Deutsche

Increased levels of intra-day volatility in the US interest rate derivatives market could make traditional approaches to estimating volatility unreliable, according to research by Deutsche Bank.

Deutsche believes there could soon be increased intra-day US interest rate derivatives volatility as the market’s focus shifts from Iraq to economic fundamentals. Volatility is traditionally estimated using closing price data, a method that fails to capture intra-day market movements.

In its latest fixed-income research note, Deutsche said a modified version of the so-called 'Garman-Klass volatility estimator' may provide traders with a more meaningful estimate of realised volatility. In this modified approach, a mathematical function is defined using opening and closing prices, in addition to the highest and lowest prices on a given day.

The relationship between the Garman-Klass volatility and classical volatility estimators varies with market conditions. In a downward trending market, the high and low prices for a given day would coincide with that day’s opening and closing prices. So in this situation, classical volatility would exceed Garman-Klass volatility because, compared with the classical estimator, the latter is calculated with relatively less weighting put on opening and closing prices. According to Deutsche’s research, the coincidence of classical and Garman-Klass estimators effectively demarcates between trending and range-bound markets.