Markov Switching GARCH Diffusion
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.
|Date of creation:||Mar 2008|
|Date of revision:|
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