Market risk and the concept of fundamental volatility: Measuring volatility across asset and derivative markets and testing for the impact of derivatives markets on ®nancial markets

This paper proposes an unobserved fundamental component of volatility as a measure of risk. This concept of fundamental volatility may be more meaningful than the usual measures of volatility for market regulators. Fundamental volatility can be obtained using a stochastic volatility model, which allows us to `®lterÕ out the signal in the volatility information. We decompose four FTSE100 stock index related volatilities into transitory noise and unobserved fundamental volatility. Our analysis is applied to the question as to whether derivative markets destabilise asset markets. We ®nd that introducing European options reduces fundamental volatility, while transitory noise in the underlying and futures markets does not show signi®cant changes. We conclude that, for the FTSE100 index, introducing a new options market has stabilised both the underlying market and existing derivative markets. Ó 2000 Elsevier Science B.V. All rights reserved. JEL classi®cation: C32; G18