l1-Penalized Likelihood Smoothing of Volatility Processes allowing for Abrupt Changes
AbstractWe consider the problem of estimating the volatility of a financial asset from a time series record of length T. We believe the underlying volatility process is smooth, possibly stationary, and with potential abrupt changes due to market news. By drawing parallels between time series and regression models, in particular between stochastic volatility models and Markov random fields smoothers, we propose a semiparametric estimator of volatility. Our Bayesian posterior mode estimate is the solution to an l1-penalized likelihood optimization that we solve with an interior point algorithm that is efficient since its complexity is bounded by O(T^3/2). We apply our volatility estimator to real financial data, diagnose the model and perform back-testing to investigate to forecasting power of the method by comparison to (I)GARCH.
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Bibliographic InfoPaper provided by Département des Sciences Économiques, Université de Genève in its series Research Papers by the Department of Economics, University of Geneva with number 2009.05.
Length: 27 pages
Date of creation: Apr 2009
Date of revision:
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l1 penalty; Markov random field; stochastic volatility model; smoothing; wavelet; extreme value theory; forecasting; GARCH.;
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