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Forecasting and testing a non-constant volatility

  • Abramov, Vyacheslav
  • Klebaner, Fima

In this paper we study volatility functions. Our main assumption is that the volatility is deterministic or stochastic but driven by a Brownian motion independent of the stock. We propose a forecasting method and check the consistency with option pricing theory. To estimate the unknown volatility function we use the approach of \cite{Goldentayer Klebaner and Liptser} based on filters for estimation of an unknown function from its noisy observations. One of the main assumptions is that the volatility is a continuous function, with derivative satisfying some smoothness conditions. The two forecasting methods correspond to the the first and second order filters, the first order filter tracks the unknown function and the second order tracks the function and it derivative. Therefore the quality of forecasting depends on the type of the volatility function: if oscillations of volatility around its average are frequent, then the first order filter seems to be appropriate, otherwise the second order filter is better. Further, in deterministic volatility models the price of options is given by the Black-Scholes formula with averaged future volatility \cite{Hull White 1987}, \cite{Stein and Stein 1991}. This enables us to compare the implied volatility with the averaged estimated historical volatility. This comparison is done for five companies and shows that the implied volatility and the historical volatilities are not statistically related.

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File URL: http://mpra.ub.uni-muenchen.de/207/1/MPRA_paper_207.pdf
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 207.

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Date of creation: 06 Jun 2006
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Handle: RePEc:pra:mprapa:207
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  1. Neil Shephard & Ole E. Barndorff-Nielsen, 2002. "Estimating quadratic variation using realised variance," Economics Series Working Papers 2001-W20, University of Oxford, Department of Economics.
  2. Ole E. Barndorff-Nielsen & Neil Shephard, 2003. "Power and bipower variation with stochastic volatility and jumps," Economics Papers 2003-W17, Economics Group, Nuffield College, University of Oxford.
  3. Andersen, Torben G. & Bollerslev, Tim & Christoffersen, Peter F. & Diebold, Francis X., 2005. "Volatility forecasting," CFS Working Paper Series 2005/08, Center for Financial Studies (CFS).
  4. Neil Shephard, 2005. "Stochastic Volatility," Economics Papers 2005-W17, Economics Group, Nuffield College, University of Oxford.
  5. Anderson, Heather M. & Vahid, Farshid, 2007. "Forecasting the Volatility of Australian Stock Returns: Do Common Factors Help?," Journal of Business & Economic Statistics, American Statistical Association, vol. 25, pages 76-90, January.
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