Volatility surprises are market moves outside the scope of expected volatility. They often bring to attention an underestimated type of risk. A paper by Aboura and Chevallier suggests that these volatility surprises transmit more easily across markets than return shocks. Moreover, the arising of unpredicted risk across markets seems to be cumulative.

Aboura, Sofiane and Julien Chevallier (2014), “Cross-Market Spillovers with ‘Volatility Surprise’”, ipag Business School, Working Paper, 2014-469,

 The below are excerpts from the paper. Emphasis and cursive text have been added.

 On the (tenuous) link between asset market volatility and fundamental risk also view post here.

On volatility markets and known and unknown risks also view post here.

The definition

“The concept of volatility surprise… represents the difference between the squared residuals (representing the unpredicted squared returns) and the conditional variance (representing the observable risk)… the volatility surprise represents the unexpected volatility component that is typically ignored, whereas common practice focuses on the predictable variance…conditional variances correspond to the ‘known unknown’… the volatility surprise is the non-predictable variance from which the unexpected risks arises.”

The research

“[The paper is] investigating volatility interactions stemming from the ‘volatility surprise’ component with cross effects and time-varying correlations in financial and commodity markets.”

“This paper focuses on volatility interactions between equities, bonds, foreign exchange rates and commodities, as further evidence is emerging for volatility to be auto-correlated within its own market and also to be cross-correlated with volatility in other asset markets…its key contribution is to document the spillover effects coming from each market’s ‘volatility surprise’ component to the remaining pairs of covariance volatilities.”

“Our analysis is performed on the long data span of 7,828 daily observations covering the period from 25 January 1983 to 25 January 2013. Four markets are represented by aggregate indices retrieved from Thomson Financial Datastream: [i]…the S&P Goldman Sachs Commodity Spot Price Index (GSCI), [ii]…the S&P 500 stock price index, [iii]…the US benchmark 10-year government bond index, [iv]…the UK GBP to USD exchange Rate.”

The key findings

“Overall, we uncover as the most striking feature that all the volatility surprises introduced (separately) as spillover variables into the combinations of pairwise volatilities are statistically significant and positive. The spillover coming from the lagged S&P500 volatility surprise is the most influential.”

“We uncover that the transmission channels across asset markets are related to the volatility surprise phenomenon, which means that a volatility shock is more likely to be transmitted from one market to another than a return shock.”

“From an asset manager’s standpoint, these findings imply that the cross-market unpredicted risks are cumulative. To build a hedging strategy against such risks, investors need to take volatility shocks into account. Variance swaps, computed on unpredicted components of implied volatility and historical volatility, can be seen as an ideal tool in this context, in order to buy and sell the volatility stemming from each market.”

“Globally, we have been able to identify strong volatility spillovers channeling through commodity markets (when paired with each one of the three other aggregate indices). These spillover effects inform us that the volatility of commodity markets is very sensitive to that of the equity, bond and foreign exchange markets. Such volatility spillovers also reflect that the risks attached to traditional financial markets can easily be transmitted to commodity markets… These inter-relationships in volatility surprise series between commodities and financial markets might be interpreted as a result of the growing integration among various asset classes (e.g. phenomenon of ‘financialization’ of commodity markets…This result contradicts the view that commodities form an alternative asset class for investments.”

“We bring to the fore the need for market practitioners and fund managers to reconsider the use of the ‘volatility surprise’ component – along with more traditional measures of volatility – to capture fully the cumulative risks at stake on financial markets.”