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Level Shifts in Volatility and the Implied-Realized Volatility Relation

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Author Info

  • Bent Jesper Christensen

    ()
    (Aarhus University and CREATES)

  • Paolo Santucci de Magistris

    ()
    (University of Pavia and CREATES)

Abstract

We propose a simple model in which realized stock market return volatility and implied volatility backed out of option prices are subject to common level shifts corresponding to movements between bull and bear markets. The model is estimated using the Kalman filter in a generalization to the multivariate case of the univariate level shift technique by Lu and Perron (2008). An application to the S&P500 index and a simulation experiment show that the recently documented empirical properties of strong persistence in volatility and forecastability of future realized volatility from current implied volatility, which have been interpreted as long memory (or fractional integration) in volatility and fractional cointegration between implied and realized volatility, are accounted for by occasional common level shifts.

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Bibliographic Info

Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2010-60.

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Length: 38
Date of creation: 09 Sep 2010
Date of revision:
Handle: RePEc:aah:create:2010-60

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Web page: http://www.econ.au.dk/afn/

Related research

Keywords: Common level shifts; fractional cointegration; fractional VECM; implied volatility; long memory; options; realized volatility.;

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