A new proxy of the average volatility of a basket of returns: A Monte Carlo study

The volatility of returns plays a pivotal role in modern finance and an accurate evaluation of this parameter is crucial in portfolio and risk management decisions. Until quite recent it was common practice in the literature to use the squared return as proxy of volatility. However, as pointed out by several authors, this measure of volatility includes a large noisy component. In this paper we propose a procedure, based on a generalized dynamic factors model methodology, to obtain a more accurate estimate of volatility of a basket of returns.