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Working Paper, No. 2009-04, September 2009
Stochastic Volatility

Given the importance of return volatility on a number of practical financial management decisions, the efforts to provide good real-time estimates and forecasts of current and future volatility have been extensive. The main framework used in this context involves stochastic volatility models. In a broad sense, this model class includes GARCH, but the authors focus on a narrower set of specifications in which volatility follows its own random process, as is common in models originating within financial economics. The distinguishing feature of these specifications is that volatility, being inherently unobservable and subject to independent random shocks, is not measurable with respect to observable information. In what follows, the authors refer to these models as genuine stochastic volatility models. Much modern asset pricing theory is built on continuous-time models. The natural concept of volatility within this setting is that of genuine stochastic volatility. For example, stochastic volatility (jump) diffusions have provided a useful tool for a wide range of applications, including the pricing of options and other derivatives, the modeling of the term structure of risk-free interest rates, and the pricing of foreign currencies and defaultable bonds. The increased use of intraday transaction data for construction of so-called realized volatility measures provides additional impetus for considering genuine stochastic volatility models. As the authors demonstrate below, the realized volatility approach is closely associated with the continuous-time stochastic volatility framework of financial economics. There are some unique challenges in dealing with genuine stochastic volatility models. For example, volatility is truly latent and this feature complicates estimation and inference. Further, the presence of an additional state variable—volatility—renders the model less tractable from an analytic perspective. They examine how such challenges have been addressed through development of new estimation methods and imposition of model restrictions allowing for closed-form solutions while remaining consistent with the dominant empirical features of the data.

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