Optimal Filtering of Jump Diffusions: Extracting Latent States from Asset Prices
Michael S. Johannes
Columbia Business School - Finance and Economics
University of Chicago - Booth School of Business
Jonathan R. Stroud
University of Pennsylvania - Statistics Department
The Review of Financial Studies, Vol. 22, Issue 7, pp. 2559-2599, 2009
This paper provides an optimal filtering methodology in discretely observed continuous-time jump-diffusion models. Although the filtering problem has received little attention, it is useful for estimating latent states, forecasting volatility and returns, computing model diagnostics such as likelihood ratios, and parameter estimation. Our approach combines time-discretization schemes with Monte Carlo methods. It is quite general, applying in nonlinear and multivariate jump-diffusion models and models with nonanalytic observation equations. We provide a detailed analysis of the filter's performance, and analyze four applications: disentangling jumps from stochastic volatility, forecasting volatility, comparing models via likelihood ratios, and filtering using option prices and returns.
Keywords: C11, C13, C15, C51, C52, G11, G12, G17
Date posted: June 22, 2009
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