Showing papers on "Volatility (finance) published in 2003"

Modeling and forecasting realized volatility

Abstract: This paper provides a general framework for integration of high-frequency intraday data into the measurement, modeling, and forecasting of daily and lower frequency volatility and return distributions. Most procedures for modeling and forecasting financial asset return volatilities, correlations, and distributions rely on restrictive and complicated parametric multivariate ARCH or stochastic volatility models, which often perform poorly at intraday frequencies. Use of realized volatility constructed from high-frequency intraday returns, in contrast, permits the use of traditional time series procedures for modeling and forecasting. Building on the theory of continuous-time arbitrage-free price processes and the theory of quadratic variation, we formally develop the links between the conditional covariance matrix and the concept of realized volatility. Next, using continuously recorded observations for the Deutschemark / Dollar and Yen / Dollar spot exchange rates covering more than a decade, we find that forecasts from a simple long-memory Gaussian vector autoregression for the logarithmic daily realized volatilities perform admirably compared to popular daily ARCH and related models. Moreover, the vector autoregressive volatility forecast, coupled with a parametric lognormal-normal mixture distribution implied by the theoretically and empirically grounded assumption of normally distributed standardized returns, gives rise to well-calibrated density forecasts of future returns, and correspondingly accurate quantile estimates. Our results hold promise for practical modeling and forecasting of the large covariance matrices relevant in asset pricing, asset allocation and financial risk management applications.

Multivariate GARCH Models: A Survey

Abstract: This paper surveys the most important developments in multivariate ARCH-type modelling. It reviews the model specifications, the inference methods, and the main areas of application of these models in financial econometrics.

Forecasting Volatility in Financial Markets: A Review

Abstract: Financial market volatility is an important input for investment, option pricing, and financial market regulation. The emphasis of this review article is on forecasting instead of modelling; it compares the volatility forecasting findings in 93 papers published and written in the last two decades. Provided in this paper as well are volatility definitions, insights into problematic issues of forecast evaluation, data frequency, extreme values and the measurement of "actual" volatility. We compare volatility forecasting performance of two main approaches; historical volatility models and volatility implied from options. Forecasting results are compared across different asset classes and geographical regions.

Overconfidence and Speculative Bubbles

Abstract: Motivated by the behavior of asset prices, trading volume, and price volatility during episodes of asset price bubbles, we present a continuous‐time equilibrium model in which overconfidence generates disagreements among agents regarding asset fundamentals. With short‐sale constraints, an asset buyer acquires an option to sell the asset to other agents when those agents have more optimistic beliefs. As in a paper by Harrison and Kreps, agents pay prices that exceed their own valuation of future dividends because they believe that in the future they will find a buyer willing to pay even more. This causes a significant bubble component in asset prices even when small differences of beliefs are sufficient to generate a trade. In equilibrium, bubbles are accompanied by large trading volume and high price volatility. Our analysis shows that while Tobin’s tax can substantially reduce speculative trading when transaction costs are small, it has only a limited impact on the size of the bubble or on price volatility.

The Impact of Jumps in Volatility and Returns

Abstract: This paper examines continuous-time stochastic volatility models incorporating jumps in returns and volatility. We develop a likelihood-based estimation strategy and provide estimates of parameters, spot volatility, jump times, and jump sizes using S&P 500 and Nasdaq 100 index returns. Estimates of jump times, jump sizes, and volatility are particularly useful for identifying the effects of these factors during periods of market stress, such as those in 1987, 1997, and 1998. Using formal and informal diagnostics, we ¢nd strong evidence for jumps in volatility and jumps in returns. Finally, we study how these factors and estimation risk impact option pricing.

International Business Cycles: World, Region, and Country-Specific Factors

Abstract: The paper investigates the common dynamic properties of business-cycle fluctuations across countries, regions, and the world. We employ a Bayesian dynamic latent factor model to estimate common components in macroeconomic aggregates (output, consumption, and investment) in a 60-country sample covering seven regions of the world. The results indicate that a common world factor is an important source of volatility for aggregates in most countries, providing evidence for a world business cycle. We find that region-specific factors play only a minor role in explaining fluctuations in economic activity. We also document similarities and differences across regions, countries, and aggregates. (JEL F41, E32, C11, C32)

Stochastic Volatility for Lévy Processes

Abstract: Three processes reflecting persistence of volatility are initially formulated by evaluating three Levy processes at a time change given by the integral of a mean-reverting square root process. The model for the mean-reverting time change is then generalized to include non-Gaussian models that are solutions to Ornstein-Uhlenbeck equations driven by one-sided discontinuous Levy processes permitting correlation with the stock. Positive stock price processes are obtained by exponentiating and mean correcting these processes, or alternatively by stochastically exponentiating these processes. The characteristic functions for the log price can be used to yield option prices via the fast Fourier transform. In general mean-corrected exponentiation performs better than employing the stochastic exponential. It is observed that the mean-corrected exponential model is not a martingale in the filtration in which it is originally defined. This leads us to formulate and investigate the important property of martingale marginals where we seek martingales in altered filtrations consistent with the one-dimensional marginal distributions of the level of the process at each future date.

The Case for Restricting Fiscal Policy Discretion

Abstract: This paper studies the effects of discretionary fiscal policy on output volatility and economic growth. Using data for 91 countries, we isolate three empirical regularities: (1) governments that use fiscal policy aggressively induce significant macroeconomic instability; (2) the volatility of output caused by discretionary fiscal policy lowers economic growth by more than 0.8 percentage points for every percentage point increase in volatility; (3) prudent use of fiscal policy is explained to a large extent by the presence of political constraints and other political and institutional variables. The evidence in the paper supports arguments for constraining discretion by imposing institutional restrictions on governments as a way to reduce output volatility and increase the rate of economic growth.

Overconfidence and Speculative Bubbles

Abstract: Motivated by the behavior of internet stock prices in 1998-2000, we present a continuous time equilibrium model of bubbles where overconfidence generates disagreements among agents regarding asset fundamentals. With short-sale constraints, an asset owner has an option to sell the asset to other over-confident agents who have more optimistic beliefs. This re-sale option has a recursive structure, that is, a buyer of the asset gets the option to resell it. This causes a significant bubble component in asset prices even when small differences of beliefs are sufficient to generate a trade. Agents pay prices that exceed their own valuation of future dividends because they believe that in the future they will find a buyer willing to pay even more. The model generates prices that are above fundamentals, excessive trading, excess volatility, and predictable returns. However, our analysis shows that while Tobin's tax can substantially reduce speculative trading when transaction costs are small, it has only a limited impact on the size of the bubble or on price volatility. We give an example where the price of a subsidiary is larger than its parent firm. Finally, we show how overconfidence can justify the use of corporate strategies that would not be rewarding in a "rational" environment.

To Float or to Fix: Evidence on the Impact of Exchange Rate Regimes on Growth

Abstract: We study the relationship between exchange rate regimes and economic growth for a sample of 183 countries over the post-Bretton Woods period , using a new de facto classification of regimes based on the actual behavior of the relevant macroeconomic variables. In contrast with previous studies, we find that, for developing countries, less flexible exchange rate regimes are associated with slower growth, as well as with greater output volatility. For industrial countries, regimes do not appear to have any significant impact on growth. The results are robust to endogeneity corrections and a number of alternative specifications borrowed from the growth literature.

Shaken and Stirred: Explaining Growth Volatility

Abstract: "If there are two or more ways to do something, and one of those ways can result in a catastrophe, then someone will do it." The economic history of the world is replete with recessions and depressions. From the bursting of the British South Sea Bubble and the French Mississippi Bubble in 1720 (which at least one economic historian claims delayed the industrial revolution by 50 years) to the industrial depressions of the 1870s and 1930s, to the Latin American middle income debt crisis, African low income debt crisis, ex-Communist output collapse, and East Asian financial crisis, crises have been a constant of market capitalism. Add to that the collapses that have accompanied non-economic shocks like wars, hurricanes, earthquakes, volcanoes, fires, pests, droughts, and floods, and it is a wonder that anyone in the world has economic security. More recently, economic crises have often tended to go hand in hand with financial crises whose frequency and severity in developing countries has increased over the past quarter century. The causes and nature of these crises have differed. For example, those that characterized the debt crises of the 1980s were precipitated by profligate governments with large cash deficits and uncontrolled monetary policies. The more recent ones have occurred in countries which, for the most part,

Delta-Hedged Gains and the Negative Market Volatility Risk Premium

Abstract: We investigate whether the volatility risk premium is negative by examining the statistical properties of delta-hedged option portfolios (buy the option and hedge with stock). Within a stochastic volatility framework, we demonstrate a correspondence between the sign and magnitude of the volatility risk premium and the mean delta-hedged portfolio returns. Using a sample of S&P 500 index options, we provide empirical tests that have the following general results. First, the delta-hedged strategy underperforms zero. Second, the documented underperformance is less for options away from the money. Third, the underperformance is greater at times of higher volatility. Fourth, the volatility risk premium significantly affects delta-hedged gains, even after accounting for jump fears. Our evidence is supportive of a negative market volatility risk premium. The notion that volatility of equity returns is stochastic has a firm footing in financial economics. However, a less than understood phenomenon is whether volatility risk is compensated, and whether this compensation is higher or lower than the risk-free rate. Is the risk from changes in market volatility positively correlated with the economy-wide pricing kernel process? If so, how does it affect the equity and option markets? Evidence that market volatility risk premium may be nonzero can be motivated by three empirical findings: Purchased options are hedges against significant market declines. This is because increased realized volatility coincides with downward market moves [French, Schwert, and Stambaugh (1987) and Glosten, Jagannathan,

Predicting Volatility: Getting the Most out of Return Data Sampled at Different Frequencies

Abstract: We use the MIDAS (Mixed Data Sampling) approach to study regressions of future realized volatility at low-frequency horizons (one to four weeks) on lagged daily and intra-daily (1) squared returns, (2) absolute returns, (3) realized volatility, (4) realized power and (5) return ranges. We document first of all that daily realized power and daily range are surprisingly good predictors of future realized volatility and outperform models based on realized volatility. Moreover, MIDAS models with daily data - range, realized power, realized volatility - require a polynomial with at least 30 days. We document that high-frequency absolute returns are also better at forecasting future low frequency realized volatility than high-frequency squared returns. We also discuss many issues that are encountered in practice, such as long memory and seasonality. All the results are based on a commonly used FX data set.

Volatility Spillover Effects in European Equity Markets

Abstract: This paper quantifies the magnitude and time-varying nature of volatility spillovers from the aggregate European (EU) and US market to 13 local European equity markets. I develop a shock spillover model that decomposes local unexpected returns into a country specific shock, a regional European shock, and a global shock from the US. The innovation of the model is that regime switches in the shock spillover parameters are accounted for. I find that these regime switches are both statistically and economically important. While both the EU and US shock spillover intensity has increased over the 1980s and 1990s, the rise is more pronounced for EU spillovers. For most countries, the largest increases in shock spillover intensity are situated in the second half of 1980s and the first half of the 1990s. Increased trade integration, equity market development, and low inflation are shown to have contributed to the increase in EU shock spillover intensity. Finally, I find some evidence for contagion from the US market to a number of local European equity markets during periods of high world market volatility.

Markowitz's Mean-Variance Portfolio Selection with Regime Switching: A Continuous-Time Model

Abstract: A continuous-time version of the Markowitz mean-variance portfolio selection model is proposed and analyzed for a market consisting of one bank account and multiple stocks. The market parameters, including the bank interest rate and the appreciation and volatility rates of the stocks, depend on the market mode that switches among a finite number of states. The random regime switching is assumed to be independent of the underlying Brownian motion. This essentially renders the underlying market incomplete. A Markov chain modulated diffusion formulation is employed to model the problem. Using techniques of stochastic linear-quadratic control, mean-variance efficient portfolios and efficient frontiers are derived explicitly in closed forms, based on solutions of two systems of linear ordinary differential equations. Related issues such as a minimum-variance portfolio and a mutual fund theorem are also addressed. All the results are markedly different from those for the case when there is no regime switching. An interesting observation is, however, that if the interest rate is deterministic, then the results exhibit (rather unexpected) similarity to their no-regime-switching counterparts, even if the stock appreciation and volatility rates are Markov-modulated.

News Arrival, Jump Dynamics and Volatility Components for Individual Stock Returns

Abstract: This paper models different components of the return distribution which are assumed to be directed by a latent news process. The conditional variance of returns is a combination of jumps and smoothly changing components. This mixture captures occasional large changes in price, due to the impact of news innovations such as earnings surprises, as well as smoother changes in prices which can result from liquidity trading or strategic trading as information disseminates. Unlike typical SV-jump models, previous realizations of both jump and normal innovations can feedback asymmetrically into expected volatility. This is a new source of asymmetry (in addition to good versus bad news) that improves forecasts of volatility particularly after large moves such as the '87 crash. A heterogeneous Poisson process governs the likelihood of jumps and is summarized by a time-varying conditional intensity parameter. The model is applied to returns from individual companies and three indices. We provide empirical evidence of the impact and feedback effects of jump versus normal return innovations, contemporaneous and lagged leverage effects, the time-series dynamics of jump clustering, and the importance of modeling the dynamics of jumps around high volatility episodes.

Pre-announcement effects, news effects, and volatility: Monetary policy and the stock market

Abstract: I examine pre-announcement and news effects on the stock market in the context of public disclosure of monetary policy decisions. The results suggest that the stock market tends to be relatively quiet – conditional volatility is abnormally low – on days preceding regularly scheduled policy announcements. Although this calming effect is routinely reported in anecdotal press accounts, it is statistically significant only over the past four to five years, a result that I attribute to changes in the Federal Reserve's disclosure practices in early 1994. The paper also looks at how the actual interest rate decisions of policy makers affect stock market volatility. The element of surprise in such decisions tends to boost stock market volatility significantly in the short run, and positive surprises – higher-than-expected values of the target federal funds rate – tend to have a larger effect on volatility than negative surprises. The implications of the results for broader issues in the finance and economics literatures are also discussed.

The Finite Moment Log Stable Process and Option Pricing

Abstract: We document a surprising pattern in S&P 500 option prices. When implied volatilities are graphed against a standard measure of moneyness, the implied volatility smirk does not flatten out as maturity increases up to the observable horizon of two years. This behavior contrasts sharply with the implications of many pricing models and with the asymptotic behavior implied by the central limit theorem (CLT). We develop a parsimonious model which deliberately violates the CLT assumptions and thus captures the observed behavior of the volatility smirk over the maturity horizon. Calibration exercises demonstrate its superior performance against several widely used alternatives.

Investigating the Behavior of Idiosyncratic Volatility

Abstract: This article studies the behavior of idiosyncratic volatility for the post–World War II period. Using aggregate idiosyncratic volatility statistics constructed from the Fama and French (1993) three‐factor model, we find that the volatility of individual stocks appears to have increased over time. This trend is not solely attributed to the increasing prominence of the NASDAQ market. We go on to suggest that the idiosyncratic volatility of individual stocks is associated with the degree to which their shares are owned by financial institutions. Finally, we show that idiosyncratic volatility is also positively related to expected earnings growth.

Has the Business Cycle Changed? Evidence and Explanations

Abstract: Over the past 30 years, economic activity has become less volatile in most G-7 countries. In the United States, for example, the standard deviation of the growth rate of GDP averaged over four quarters was one-third less during 1984 to 2002 than it was during 1960 to 1983. This decline in volatility is widespread across sectors within the United States and is also found in the other G-7 economies, although the timing and details differ from one country to the next. Interestingly, despite these changes and increasing international economic integration, output fluctuations have not become more correlated or synchronized across countries.

Dynamic asset allocation with event risk

Abstract: An inherent risk facing investors in financial markets is that a major event may trigger a large abrupt change in stock prices and market volatility. This paper studies the implications of jumps in prices and volatility on investment strategies. Using the event-risk framework of Duffie, Pan, and Singleton, we provide an analytical solution to the optimal portfolio problem. We find that event risk dramatically affects the optimal strategy. An investor facing event risk is less willing to take leveraged or short positions. In addition, the investor acts as if some portion of his wealth may become illiquid and the optimal strategy blends elements of both dynamic and buy-and-hold portfolio strategies. Jumps in prices and volatility both have an important influence on the optimal strategy.

Financial Integration and Macroeconomic Volatility

Abstract: This paper examines the impact of international financial integration on macroeconomic volatility. Economic theory does not provide a clear guide to the effects of financial integration on volatility, implying that this is essentially an empirical question. We provide a comprehensive examination of changes in macroeconomic volatility in a large group of industrial and developing economies over the period 1960-99. We report two major results: First, while the volatility of output growth has, on average, declined in the 1990s relative to the three earlier decades, we also document that, on average, the volatility of consumption growth relative to that of income growth has increased for more financially integrated developing economies in the 1990s. Second, increasing financial openness is associated with rising relative volatility of consumption, but only up to a certain threshold. The benefits of financial integration in terms of improved risk-sharing and consumption-smoothing possibilities appear to accrue only beyond this threshold.

Trade Reforms, Labor Regulations and Labor-Demand Elasticities: Empirical Evidence from India

Abstract: This paper finds a positive impact of trade liberalization on labor-demand elasticities in the Indian manufacturing sector using industry-level data disaggregated by states These elasticities turn out to be negatively related to protection levels that vary across industries and over time Furthermore, we find that these elasticities are higher for Indian states with flexible labor regulations where they are also impacted more by trade reforms Finally, we find that after the reforms, volatility in productivity and output gets translated into larger wage and employment volatility, theoretically a possible consequence of larger labor-demand elasticities