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A Class of Nonlinear Stochastic Volatility Models and Its Implications on Pricing Currency Options

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  • Jun Yu
  • Zhenlin Yang
  • Xibin Zhang

Abstract

This paper proposes a class of stochastic volatility (SV) models which offers an alternative to the one introduced in Andersen (1994). The class encompasses all standard SV models that have appeared in the literature, including the well known lognormal model, and allows us to empirically test all standard specifications in a convenient way. We develop a likelihood-based technique for analyzing the class. Daily dollar/pound exchange rate data reject all the standard models and suggest evidence of nonlinear SV. An efficient algorithm is proposed to study the implications of this nonlinear SV on pricing currency options and it is found that the lognormal model overprices options.

Suggested Citation

  • Jun Yu & Zhenlin Yang & Xibin Zhang, 2002. "A Class of Nonlinear Stochastic Volatility Models and Its Implications on Pricing Currency Options," Monash Econometrics and Business Statistics Working Papers 17/02, Monash University, Department of Econometrics and Business Statistics.
    • Handle: RePEc:msh:ebswps:2002-17
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    More about this item

    Keywords

    Box-Cox transformations; Stochastic volatility; MCMC; Exchange rate volatility; Option pricing.;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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