Volatility Components, Affine Restrictions and Non-Normal Innovations

41 Pages Posted: 5 May 2008 Last revised: 21 Nov 2008

See all articles by Peter Christoffersen

Peter Christoffersen

University of Toronto - Rotman School of Management; Copenhagen Business School; Aarhus University - CREATES

Christian Dorion

HEC Montreal

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Yintian Wang

McGill University - Desautels Faculty of Management

Multiple version iconThere are 2 versions of this paper

Date Written: September 24, 2008

Abstract

Recent work by Engle and Lee (1999) shows that allowing for long-run and short-run components greatly enhances a GARCH model's ability to 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; for the non-affine models, the evidence is somewhat less convincing in option valuation. The evidence in favor of the non-normal GED models is strong when fitting daily returns, but the non-normal models do not provide much improvement when valuing options.

Keywords: Volatility, Component Model, GARCH, Long Memory, Option Valuation, Affine, Normality

JEL Classification: C22, G13

Suggested Citation

Christoffersen, Peter and Dorion, Christian and Jacobs, Kris and Wang, Yintian, Volatility Components, Affine Restrictions and Non-Normal Innovations (September 24, 2008). Available at SSRN: https://ssrn.com/abstract=1129230 or http://dx.doi.org/10.2139/ssrn.1129230

Peter Christoffersen (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5P 3C4
Canada
416-946-5511 (Phone)

HOME PAGE: http://www.christoffersen.com

Copenhagen Business School

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

Aarhus University - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Christian Dorion

HEC Montreal ( email )

3000, Chemin de la Côte-Sainte-Catherine
Montreal, Quebec H2X 2L3
Canada
5143401522 (Phone)
5143405632 (Fax)

HOME PAGE: http://neumann.hec.ca/pages/christian.dorion/

Kris Jacobs

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Yintian Wang

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada

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