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Volatility Bursts: A Discrete-Time Option Model with Multiple Volatility Components

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  • Francesca Lilla

Abstract

I propose an affine discrete-time model, called Vector Autoregressive Gamma with volatility Bursts (VARG-B) in which volatility experiences, in addition to frequent and small changes, periods of sudden and extreme movements generated by a latent factor which evolves according to the Autoregressive Gamma Zero process. A key advantage of the discrete-time specification is the possibility of estimating the model using Kalman Filter techniques. Moreover, the VARG-B model leads to a fully analytic conditional Laplace transform which boils down to a closed-form option pricing formula. When estimated on S&P500 index options and returns, the new model provides more accurate option pricing and modeling of the IV surface compared with some alternative models.

Suggested Citation

  • Francesca Lilla, 2023. "Volatility Bursts: A Discrete-Time Option Model with Multiple Volatility Components," Journal of Financial Econometrics, Oxford University Press, vol. 21(3), pages 678-713.
    • Handle: RePEc:oup:jfinec:v:21:y:2023:i:3:p:678-713.
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbab015
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    More about this item

    Keywords

    ARG-zero; Kalman filter; option pricing; realized volatility; volatility bursts;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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