Latent Integrated Stochastic Volatility, Realized Volatility, and Implied Volatility: A State Space Approach

Christian Bach, Bent Jesper Christensen

    Research output: Working paper/Preprint Working paperResearch

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    Abstract

    We include simultaneously both realized volatility measures based on high-frequency asset returns and implied volatilities backed out of individual traded at the money option prices in a state space approach to the analysis of true underlying volatility. We model integrated volatility as a latent fi…rst order Markov process and show that our model is closely related to the CEV and Barndorff-Nielsen & Shephard (2001) models for local volatility. We show that if measurement noise in the observable volatility proxies is not accounted for, then the estimated autoregressive parameter in the latent process is downward biased. Implied volatility performs better than any of the alternative realized measures when forecasting future integrated volatility. The results are largely similar across the stock market (S&P 500), bond market (30-year U.S. T-bond), and foreign currency exchange market ($/£ ).
    Original languageEnglish
    Place of publicationAarhus
    PublisherCREATES, Institut for Økonomi, Aarhus Universitet
    Number of pages36
    Publication statusPublished - 14 Feb 2010

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