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Markov Switching GARCH Diffusion

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Author Info

  • Carol Alexander

    ()
    (ICMA Centre, University of Reading)

  • Emese Lazar

    (ICMA Centre, University of Reading)

Abstract

GARCH option pricing models have the advantage of a well-established econometric foundation. However, multiple states need to be introduced as single state GARCH and even Levy processes are unable to explain the term structure of the moments of financial data. We show that the continuous time version of the Markov switching GARCH(1,1) process is a stochastic model where the volatility follows a switching process. The continuous time switching GARCH model derived in this paper, where the variance process jumps between two or more GARCH volatility states, is able to capture the features of implied volatilities in an intuitive and tractable framework.

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Bibliographic Info

Paper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2008-01.

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Length: 30 pages
Date of creation: Mar 2008
Date of revision:
Handle: RePEc:rdg:icmadp:icma-dp2008-01

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Related research

Keywords: GARCH; jumps; normal mixture; Markov switching; stochastic volatility; time aggregation;

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Cited by:
  1. Bildirici, Melike & Ersin, Özgür, 2012. "Nonlinear volatility models in economics: smooth transition and neural network augmented GARCH, APGARCH, FIGARCH and FIAPGARCH models," MPRA Paper 40330, University Library of Munich, Germany, revised May 2012.

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