Level Shifts in Volatility and the Implied-Realized Volatility Relation
AbstractWe 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 InfoPaper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2010-60.
Date of creation: 09 Sep 2010
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Web page: http://www.econ.au.dk/afn/
Common level shifts; fractional cointegration; fractional VECM; implied volatility; long memory; options; realized volatility.;
Find related papers by JEL classification:
- C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
- G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-09-25 (All new papers)
- NEP-BEC-2010-09-25 (Business Economics)
- NEP-ECM-2010-09-25 (Econometrics)
- NEP-ETS-2010-09-25 (Econometric Time Series)
- NEP-FMK-2010-09-25 (Financial Markets)
- NEP-FOR-2010-09-25 (Forecasting)
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