Stochastic Volatility Models

From: Collector's Blog | July 08, 2009

Every stochastic volatility model assumes yes stochastic volatility. All the stochastic volatility models I have looked into however assume constant volatility of volatility. Empirical research (mostly unpublished) shows the volatilRead more at Collector's Blog »

Comments (2)

1. 

   The models are phenomenological and require input of the parameters and so can never be predictive for all scenarios. Sometimes (as in Hull's book) you find that people use a model such as (if I remember correctly) Black's model (rather than Black and Scholes) and forgive me if I got the name wrong, to model for example products that depend on interest rates (which according to Hull have mean reversion and so are not behaving like a Brownian motion) and somehow this model "works out" or "works better" than the B-S because although not intended for this it makes the right outputs. The point to remember is that all of these models are phenomenological and depend on estimates of the inputs such as "historical volatility" and volatility of volatility, so that they are both of academic interest and of engineering interest (see how well they might work in practice). As an analogy consider turbulence modelling which makes some assumptions to close the equations - it works for some geometries but needs a lot of adjustment or fails for others. So I guess the thing to do is construct and study these models and then somehow evaluate them for different scenarios and issue recommendations as to how and when to use them? More than one model (and quite differently motivated models) may give the same outputs. In recent years ways of speaking in averages (fuzzy logic) have been as effective as complex control theories in practical engineering.

   By Daniel Howard Director at Howard Science Limited

   posted 54 minutes ago

2. 

   I am going to be presenting a paper on Volatility Modeling and Trading at the upcoming Quant USA conference in New York next week in which I discuss a very effective stochastic volatility of volatility model, the ARFIMA-GARCH model. It models volatility as a long memory process which is disturbed by shocks from the volatility of volatility process, which evolves in GARCH form.
   The paper evaluates the performance of the model in trading S&P options.
   
   More on the conference here: http://web.incisive-events.com/rma/2009/07/quant-congress-usa/index.html
   
   More details on my Quantitative Investment and Trading blog to come:http://quantinvestment.blogspot.com/

   By Jonathan Kinlay, PhD (jkinlay@investment-analytics.com)

Using Volatility to Predict Market Direction

Decomposing Asset Returns

We can decompose the returns process R_t as follows:

While the left hand side of the equation is essentially unforecastable, both of the right-hand-side components of returns display persistent dynamics and hence are forecastable. Both the signs of returns and magnitude of returns are conditional mean dependent and hence forecastable, but their product is conditional mean independent and hence unforecastable. This is an example of a nonlinear “common feature” in the sense of Engle and Kozicki (1993).

Although asset returns are essentially unforecastable, the same is not true for asset return signs (i.e. the direction-of-change). As long as expected returns are nonzero, one should expect sign dependence, given the overwhelming evidence of volatility dependence. Even in assets where expected returns are zero, sign dependence may be induced by skewness in the asset returns process. Hence market timing ability is a very real possibility, depending on the relationship between the mean of the asset returns process and its higher moments. The highly nonlinear nature of the relationship means that conditional sign dependence is not likely to be found by traditional measures such as signs autocorrelations, runs tests or traditional market timing tests. Sign dependence is likely to be strongest at intermediate horizons of 1-3 months, and unlikely to be important at very low or high frequencies. Empirical tests demonstrate that sign dependence is very much present in actual US equity returns, with probabilities of positive returns rising to 65% or higher at various points over the last 20 years. A simple logit regression model captures the essentials of the relationship very successfully.

Now consider the implications of dependence and hence forecastability in the sign of asset returns, or, equivalently, the direction-of-change. It may be possible to develop profitable trading strategies if one can successfully time the market, regardless of whether or not one is able to forecast the returns themselves.

There is substantial evidence that sign forecasting can often be done successfully. Relevant research on this topic includes Breen, Glosten and Jaganathan (1989), Leitch and Tanner (1991), Wagner, Shellans and Paul (1992), Pesaran and Timmerman (1995), Kuan and Liu (1995), Larsen and Wozniak (10050, Womack (1996), Gencay (1998), Leung Daouk and Chen (1999), Elliott and Ito (1999) White (2000), Pesaran and Timmerman (2000), and Cheung, Chinn and Pascual (2003).

There is also a huge body of empirical research pointing to the conditional dependence and forecastability of asset volatility. Bollerslev, Chou and Kramer (1992) review evidence in the GARCH framework, Ghysels, Harvey and Renault (1996) survey results from stochastic volatility modeling, while Andersen, Bollerslev and Diebold (2003) survey results from realized volatility modeling.

Sign Dynamics Driven By Volatility Dynamics

Let the returns process R_t be Normally distributed with mean m and conditional volatility s_t.

The probability of a positive return Pr[R_t+1 >0] is given by the Normal CDF F=1-Prob[0,f]

For a given mean return, m, the probability of a positive return is a function of conditional volatility s_t. As the conditional volatility increases, the probability of a positive return falls, as illustrated in Figure 1 below with m = 10% and s_t = 5% and 15%.

In the former case, the probability of a positive return is greater because more of the probability mass lies to the right of the origin. Despite having the same, constant expected return of 10%, the process has a greater chance of generating a positive return in the first case than in the second. Thus volatility dynamics drive sign dynamics.

Figure 1

Email me at jkinlay@investment-analytics.com.com for a copy of the complete article.

EuroPlace Finance Forum Paris

I have just returned from the EuroPlace Finance Forum in Paris, accompanied by my colleague and business partner Ron Henley.

The event, which has been running for several years, was very well organized and attended, with interesting and highly topical presentations and discussions of current financial and economic events, focusing primarily on the current financial crisis and plans for economic recovery. Attendees included finance ministers from Eu and non-Eu countries, Heads of Investment and Commercial banks, Chief Economists and Heads of Research from buy- and sell-side institutions, and Chief Investment Officers from several well-known asset management firms.