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Pricing Central Tendency in Volatility

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  • Stanislav Khrapov

    () (New Economic School)

Abstract

It is widely accepted that there is a risk of fluctuating volatility. There is some evidence, analogously to long-term consumption risk literature or central tendency in interest rates, that there exists a slowly varying component in volatility. Volatility literature concentrates on investigation of two-factor volatility process, with one factor being very persistent. I propose a different parametrization of volatility process that includes this persistent component as a stochastic central tendency. The reparametrization is observationally equivalent but has compelling economic interpretation. I estimate the historical and riskneutral parameters of the model jointly using GMM with the data on realized volatility and VIX volatility index and treating central tendency as completely unobservable. The main empirical result of the paper is that on average the volatility premium is mainly due to the premium on highly persistent shocks of the central tendency.

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Bibliographic Info

Paper provided by Center for Economic and Financial Research (CEFIR) in its series Working Papers with number w0168.

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Length: 57 pages
Date of creation: Oct 2011
Date of revision:
Handle: RePEc:cfr:cefirw:w0168

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Keywords: stochastic volatility; central tendency; volatility risk premium; GMM;

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References

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