Design of Volatility Model in Nifty 50 Index using Thin Plate Spline Regression

Abstract

<p>The analysis of volatility in stock markets has important consequences for investors and traders. The presence of volatility increases market risks and therefore discourages investment in the stock market. The proper study and understanding of volatility is needed for prudent risk management. In this paper, the market volatility in the National Stock Exchange in India as measured by the India Volatility Index is analyzed. The daily volatility in NIFTY 50 index is regressed on the price to earnings ratio and the volatility of previous day. The market volatility within a period of time is highly correlated and the highly volatile periods coincide with large impact negative events on a national and global scale. The Price to Earnings ratio represent the fundamentals of the market and it also strongly influences the price movements. The nonlinear regression problem is formulated and solved using thin plate spline regression technique. This effectively captures the nonlinear aspect of the problem. Results indicate that volatility has high upward correlation during middle range of P/E ratios than in the upper and lower ranges. Therefore risk management techniques using option derivatives are more important during the middle range of values of P/E ratio.</p>