37 Pages Posted: 25 Jul 2008 Last revised: 7 Jun 2011
Date Written: July 17, 2008
In this paper, we incorporate time-varying mixing probabilities into univariate and bivariate mixture multiplicative error models. Switching between the regimes is governed by an observable predetermined variable. The models are applicable to positive-valued time series, and are particularly well-suited for different financial volatility measures. The flexibility afforded by non-constant regime probabilities facilitates capturing the high persistence in financial volatility regimes, as well as time-varying volatility of volatility. We apply the new models to the implied volatilities of call and put options on the USD/EUR exchange rate, using the lagged daily exchange rate return as the regime indicator. In one-step-ahead forecasting, both mean squared errors and directional accuracy improve when allowing for time-varying mixing probabilities. Further improvements are brought about by employing a bivariate instead of a univariate model.
Suggested Citation: Suggested Citation
Ahoniemi, Katja and Lanne, Markku, Time-Varying Mixture Multiplicative Error Models for Implied Volatility (July 17, 2008). Available at SSRN: https://ssrn.com/abstract=1176203 or http://dx.doi.org/10.2139/ssrn.1176203