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Latent Integrated Stochastic Volatility, Realized Volatility, and Implied Volatility: A State Space Approach

  • Christian Bach

    ()

    (Aarhus University, School of Economics and Management and CREATES)

  • Bent Jesper Christensen

    ()

    (Aarhus University, School of Economics and Management and CREATES)

We include simultaneously both realized volatility measures based on high-frequency asset returns and implied volatilities backed out of individual traded at the money option prices in a state space approach to the analysis of true underlying volatility. We model integrated volatility as a latent fi?rst order Markov process and show that our model is closely related to the CEV and Barndorff-Nielsen & Shephard (2001) models for local volatility. We show that if measurement noise in the observable volatility proxies is not accounted for, then the estimated autoregressive parameter in the latent process is downward biased. Implied volatility performs better than any of the alternative realized measures when forecasting future integrated volatility. The results are largely similar across the stock market (S&P 500), bond market (30-year U.S. T-bond), and foreign currency exchange market ($/£ ).

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File URL: ftp://ftp.econ.au.dk/creates/rp/10/rp10_61.pdf
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Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2010-61.

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Length: 36
Date of creation: 11 Feb 2011
Date of revision:
Handle: RePEc:aah:create:2010-61
Contact details of provider: Web page: http://www.econ.au.dk/afn/

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