Faculty Digital Archive

Archive@NYU >
Stern School of Business >
IOMS: Information Systems Working Papers >

Please use this identifier to cite or link to this item: http://hdl.handle.net/2451/14172

Title: Modeling Volatility Using State Space Models
Authors: Timmer, Jens
Weigend, Andreas S.
Issue Date: Nov-1997
Publisher: Stern School of Business, New York University
Series/Report no.: IS-97-11
Abstract: In time series problems, noise can be divided into two categories: dynamic noise which drives the process, and observational noise which is added in the measurement process, but does not influence future values of the system. In this framework, empirical volatilities (the squared relative returns of prices) exhibit a significant amount of observational noise. To model and predict their time evolution adequately, we estimate state space models that explicitly include observational noise. We obtain relaxation times for shocks in the logarithm of volatility ranging from three weeks (for foreign exchange) to three to five months (for stock indices). In most cases, a two-dimensional hidden state is required to yield residuals that are consistent with white noise. We compare these results with ordinary autoregressive models (without a hidden state) and find that autoregressive models underestimate the relaxation times by about two orders of magnitude due to their ignoring the distinction between observational and dynamic noise. This new interpretation of the dynamics of volatility in terms of relaxators in a state space model carries over to stochastic volatility models and to GARCH models, and is useful for several problems in finance, including risk management and the pricing of derivative securities.
URI: http://hdl.handle.net/2451/14172
Appears in Collections:IOMS: Information Systems Working Papers

Files in This Item:

File Description SizeFormat
IS-97-11.pdf3.35 MBAdobe PDFView/Open

Items in Faculty Digital Archive are protected by copyright, with all rights reserved, unless otherwise indicated.


The contents of the FDA may be subject to copyright, be offered under a Creative Commons license, or be in the public domain.
Please check items for rights statements. For information about NYU’s copyright policy, see http://www.nyu.edu/footer/copyright-and-fair-use.html 
Valid XHTML 1.0 | CSS