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Implied Probability Measures of Volatility

Listed author(s):
  • Carlos Fuertes
  • Andrew Papanicolaou
Registered author(s):

    We explore the inversion of derivatives prices to obtain an implied probability measure on volatility's hidden state. Stochastic volatility is a hidden Markov model (HMM), and HMMs ordinarily warrant filtering. However, derivative data is a set of conditional expectations that are already observed in the market, so rather than use filtering techniques we compute an \textit{implied distribution} by inverting the market's option prices. Robustness is an issue when model parameters are probably unknown, but isn't crippling in practical settings because the data is sufficiently imprecise and prevents us from reducing the fitting error down to levels where parameter uncertainty will show. When applied to SPX data, the estimated model and implied distributions produce variance swap rates that are consistent with the VIX, and also pick up some of the monthly effects that occur from option expiration. We find that parsimony of the Heston model is beneficial because we are able to decipher behavior in estimated parameters and implied measures, whereas the richer Heston model with jumps produces a better fit but also has implied behavior that is less revealing.

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    Paper provided by in its series Papers with number 1203.6631.

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    Date of creation: Mar 2012
    Date of revision: Oct 2012
    Handle: RePEc:arx:papers:1203.6631
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