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What is the Square Root Rule?

Volatility and VaR can be scaled using the square root of time rule. According to this rule, if the fluctuations in a stochastic process are independent of each other, then the volatility will increase by square root of time. It provides exact volatilities if the volatilities are based on lognormal returns. In case of simple returns the scaled volatilities are approximate.

Let’s say the monthly volatility is 5%, then the annual volatility will be 0.05*Sqrt(12) = 17.32%.

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