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News or Noise? Signal Extraction Can Generate Volatility Clusters From IID Shocks

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  • Prasad Bidarkota

    ()
    (Department of Economics, Florida International University)

  • J. Huston McCulloch

    (Department of Economics, Ohio State University)

Abstract

We develop a framework in which information about firm value is noisily observed. Investors are then faced with a signal extraction problem. Solving this would enable them to probabilistically infer the fundamental value of the firm and, hence, price its stocks. If the innovations driving the fundamental value of the firm and the noise that obscures this fundamental value in observed data come from non-Gaussian thick-tailed probability distributions, then the implied stock returns could exhibit volatility clustering. We demonstrate the validity of this effect with a simulation study.

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File URL: http://casgroup.fiu.edu/pages/docs/2248/1280267790_03-04.pdf
File Function: First version, 2003
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Bibliographic Info

Paper provided by Florida International University, Department of Economics in its series Working Papers with number 0304.

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Length: 38 pages
Date of creation: Nov 2003
Date of revision:
Handle: RePEc:fiu:wpaper:0304

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Web page: http://casgroup.fiu.edu/Economics/
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Keywords: stock returns; volatility clusters; GARCH processes; signal extraction; thick-tailed distributions; simulations;

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  2. French, Kenneth R. & Schwert, G. William & Stambaugh, Robert F., 1987. "Expected stock returns and volatility," Journal of Financial Economics, Elsevier, vol. 19(1), pages 3-29, September.
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  4. French, Kenneth R. & Roll, Richard, 1986. "Stock return variances : The arrival of information and the reaction of traders," Journal of Financial Economics, Elsevier, vol. 17(1), pages 5-26, September.
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  15. McCulloch, J. Huston, 1985. "Interest-risk sensitive deposit insurance premia : Stable ACH estimates," Journal of Banking & Finance, Elsevier, vol. 9(1), pages 137-156, March.
  16. Prasad V. Bidarkota, 2003. "Do Fluctuations in U.S. Inflation Rates Reflect Infrequent Large Shocks or Frequent Small Shocks?," The Review of Economics and Statistics, MIT Press, vol. 85(3), pages 765-771, August.
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