Department of Economics and Business Economics

Volatility Components, Affine Restrictions and Non-Normal Innovations

Research output: Working paperResearch

  • Peter Christoffersen, Denmark
  • Kris Jacobs, McGill University, Canada
  • Christian Dorian, McGill University, Canada
  • Yintian Wang, Tsinghua University, China
  • School of Economics and Management
Recent work by Engle and Lee (1999) shows that allowing for long-run and short-run components
greatly enhances a GARCH model's ability fit daily equity return dynamics. Using
the risk-neutralization in Duan (1995), we assess the option valuation performance of the
Engle-Lee model and compare it to the standard one-component GARCH(1,1) model. We
also compare these non-affine GARCH models to one- and two- component models from the
class of affine GARCH models developed in Heston and Nandi (2000). Using the option pricing
methodology in Duan (1999), we then compare the four conditionally normal GARCH
models to four conditionally non-normal versions. As in Hsieh and Ritchken (2005), we find
that non-affine models dominate affine models both in terms of fitting return and in terms
of option valuation. For the affine models we find strong evidence in favor of the component
structure for both returns and options, but for the non-affine models the evidence is much
less strong in option valuation. The evidence in favor of the non-normal models is strong
when fitting daily returns, but the non-normal models do not provide much improvement
when valuing options.
Original languageEnglish
Place of publicationAarhus
PublisherInstitut for Økonomi, Aarhus Universitet
Number of pages41
Publication statusPublished - 2008

    Research areas

  • Volatility; Component Model; GARCH; Long Memory; Option Valuation; Affine; Normality

See relations at Aarhus University Citationformats

ID: 10571519