Estimation of Stochastic Volatility Models : An Approximation to the Nonlinear State Space
AbstractThe stochastic volatility (SV) models had not been popular as the ARCH (autoregressive conditional heteroskedasticity) models in practical applications until recent years even though the SV models have close relationship to financial economic theories. The main reason is that the likelihood of the SV models is not easy to evaluate unlike the ARCH models. Developments of Markov Chain Monte-Carlo (MCMC) methods have increased the popularity of Bayesian inference in many fields of research including the SV models. After Jacquire et al. (1994) applied a Bayesian analysis for estimating the SV model in their epoch making work, the Bayesian approach has greatly contributed to the research on the SV models. The classical analysis based on the likelihood for estimating the (SV) model has been extensively studied in the recent years. Danielson (1994) approximates the marginal likelihood of the observable process by simulating the latent volatility conditional on the available information. Shephard and Pitt (1997) gave an idea of evaluating likelihood by exploiting sampled volatility. Durbin and Koopman (1997) explored the idea of Shephard and Pitt (1997) and evaluated the likelihood by Monte-Carlo integration. Sandmann and Koopman (1998) applied this method for the SV model. Durbin and Koopman (2000) reviewed the methods of Monte Carlo maximum likelihood from both Bayesian and classical perspectives. The purpose of this paper is to propose the Laplace approximation (LA) method to the nonlinear state space representation, and to show that the LA method is workable for estimating the SV models including the multivariate SV model and the dynamic bivariate mixture (DBM) model. The SV model can be regarded as a nonlinear state space model. The LA method approximates the logarithm of the joint density of current observation and volatility conditional on the past observations by the second order Taylor expansion around its mode, and then applies the nonlinear filtering algorithm. This idea of approximation is found in Shephard and Pitt (1997) and Durbin and Koopmann (1997). The Monte-Carlo Likelihood (MCL: Sandmann and Koopman (1998)) is now a standard classical method for estimating the SV models. It is based on importance sampling technique. Importance sampling is regarded as an exact method for maximum likelihood estimation. We show that the LA method of this paper approximates the weight function by unity in the context of importance sampling. We do not need to carry out the Monte Carlo integration for obtaining the likelihood since the approximate likelihood function can be analytically obtained. If one-step ahead prediction density of observation and volatility variables conditional on the past observations is sufficiently accurately approximated, the LA method is workable. We examine how the LA method works by simulations as well as various empirical studies. We conduct the Monte-Carlo simulations for the univariate SV model for examining the small sample properties and compare them with those of other methods. Simulation experiments reveals that our method is comparable to the MCL, Maximum Likelihood (Fridman and Harris (1998)) and MCMC methods. We apply this method to the univariate SV models with normal distribution or t-distribution, the bivariate SV model and the dynamic bivariate mixture model, and empirically illustrate how the LA method works for each of the extended models. The empirical results on the stock markets reveal that our method provides very similar estimates of coefficients to those of the MCL. As a result, this paper demonstrates that the LA method is workable in two ways: simulation studies and empirical studies. Naturally, the workability is limited to the cases we have examined. But we believe the LA method is applicable to many SV models based on our study of this paper
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Stochastic volatility; Nonlinear state space representation;
Find related papers by JEL classification:
- C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
- C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models &bull Diffusion Processes
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-06-03 (All new papers)
- NEP-ECM-2006-06-03 (Econometrics)
- NEP-ETS-2006-06-03 (Econometric Time Series)
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