Post by Sapphire Capital on Jul 23, 2008 21:26:00 GMT 4
Maximum Likelihood Estimation and Dynamic Asset Allocation with Non-Affine Volatility Processes
KYRIAKOS CHOURDAKIS
FitchSolutions; CCFEA
GEORGE DOTSIS
University of Essex - School of Accounting, Finance and Management
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Abstract:
In this paper we develop an estimation method for extracting non-affine latent stochastic volatility and risk premia from measures of model-free realized and risk-neutral integrated volatility. We estimate non-affine models with nonlinear drift and constant elasticity of variance and we compare them to the popular square root stochastic volatility model. Our empirical findings are: (1) the square root model is largely mispespified; (2) the inclusion of constant elasticity of variance and nonlinear drift is of crucial importance; (3) models with linear drift imply an explosive volatility process under the risk neutral probability measure. To gauge the economic impact of the empirical findings we also study the impact of non-affine specifications on dynamic asset allocation strategies with stochastic volatility. We show that, in contrast to the affine case, non-affine volatility processes induce market timing and constant elasticity of variance generates substantial intertemporal hedging demands.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1136049_code258765.pdf?abstractid=1136049&mirid=3
KYRIAKOS CHOURDAKIS
FitchSolutions; CCFEA
GEORGE DOTSIS
University of Essex - School of Accounting, Finance and Management
--------------------------------------------------------------------------------
Abstract:
In this paper we develop an estimation method for extracting non-affine latent stochastic volatility and risk premia from measures of model-free realized and risk-neutral integrated volatility. We estimate non-affine models with nonlinear drift and constant elasticity of variance and we compare them to the popular square root stochastic volatility model. Our empirical findings are: (1) the square root model is largely mispespified; (2) the inclusion of constant elasticity of variance and nonlinear drift is of crucial importance; (3) models with linear drift imply an explosive volatility process under the risk neutral probability measure. To gauge the economic impact of the empirical findings we also study the impact of non-affine specifications on dynamic asset allocation strategies with stochastic volatility. We show that, in contrast to the affine case, non-affine volatility processes induce market timing and constant elasticity of variance generates substantial intertemporal hedging demands.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1136049_code258765.pdf?abstractid=1136049&mirid=3