How Relevant is Volatility Forecasting for Financial Risk Management?

It depends. If volatility fluctuates in a forecastable way, then volatility forecasts are useful for risk management; hence the interest in volatility forecastability in the risk management literature. Volatility forecastability, however, varies with horizon, and different horizons are relevant in different applications. Moreover, existing assessments of volatility forecastability are plagued by the fact that they are joint assessments of volatility forecastability and an assumed model, and the results can vary not only with the horizon, but also with the assumed model. To address this problem, we develop a model-free procedure for assessing volatility forecastability across horizons. Perhaps surprisingly, we find that volatility forecastability decays quickly with horizon. Volatility forecastability, although clearly of relevance for risk management at the short horizons relevant for, say, trading desk management, may be much less important at longer horizons. Acknowledgments: We thank the Editor (John Campbell) for helpful comments, as well as seminar participants at Princeton University, the University of Virginia, the Bank of England, the Bank of Italy, the Federal Reserve Bank of New York, Goldman Sachs, London Business School, the NBER Conference on Market Microstructure, and the Newton Institute Workshop on Econometrics and Financial Time Series. Rob Engle, Greg Hopper, Eric Jacquier, Bruce Lehman, and Keith Sill provided helpful discussion. All remaining inadequacies are ours alone. We thank the National Science Foundation, FCAR and SSHRC for support. See Santomero (1995, 1997) and Babbel and Santomero (1997). 4 See, for example, Kupiec and O’Brien (1995). 5 1