Maximum Likelihood Estimation and Dynamic Asset Allocation with Non-Affine Volatility Processes

42 Pages Posted: 23 May 2008 Last revised: 3 Feb 2009

See all articles by Kyriakos Chourdakis

Kyriakos Chourdakis

FitchSolutions; CCFEA

George Dotsis

National Kapodistrian University of Athens - Faculty of Economics; Essex Finance Centre, Essex Business School, University of Essex

Date Written: January 2, 2009

Abstract

In this paper we develop an estimation method for extracting non-affine latent stochastic volatility and risk premia from measures of model-free realized and risk-neutral integrated volatility. We estimate non-affine models with nonlinear drift and constant elasticity of variance and we compare them to the popular square-root stochastic volatility model. Our empirical findings are: (1) the square-root model is misspecified; (2) the inclusion of constant elasticity of variance and nonlinear drift captures stylized facts of volatility dynamics; (3) models with linear drift imply an explosive volatility process under the risk-neutral probability measure. To gauge the economic impact of the empirical findings we also study the implications of non-affine specifications on dynamic asset allocation strategies with stochastic volatility. We show that, in contrast to the affine case, non-affine volatility models induce market timing and can generate volatility dynamics which are volatile enough to produce large intertemporal hedging demands.

Keywords: Non-Affine Volatility, Integrated Volatility, Volatility Risk Premium, Markov Chain Approximation, Asset Allocation

JEL Classification: G11, G12, C52

Suggested Citation

Chourdakis, Kyriakos and Dotsis, George, Maximum Likelihood Estimation and Dynamic Asset Allocation with Non-Affine Volatility Processes (January 2, 2009). Available at SSRN: https://ssrn.com/abstract=1136049 or http://dx.doi.org/10.2139/ssrn.1136049

Kyriakos Chourdakis (Contact Author)

FitchSolutions ( email )

101 Finsbury Pavement
London
United Kingdom

CCFEA ( email )

Wivenhoe Park
Colchester, Essex CO4 3SQ
United Kingdom

George Dotsis

National Kapodistrian University of Athens - Faculty of Economics ( email )

Greece

HOME PAGE: http://sites.google.com/site/gdotsis/

Essex Finance Centre, Essex Business School, University of Essex ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom

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