Time-Varying Mixture Multiplicative Error Models for Implied Volatility

37 Pages Posted: 25 Jul 2008 Last revised: 7 Jun 2011

Katja Ahoniemi

Imperial College Business School

Markku Lanne

University of Helsinki - Department of Political and Economic Studies

Date Written: July 17, 2008

Abstract

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

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

Katja Ahoniemi (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
London, SW7 2AZ
United Kingdom

Markku Lanne

University of Helsinki - Department of Political and Economic Studies ( email )

P.O. Box 54
FIN-00014 Helsinki
Finland
+358-9-191 24626 (Phone)
+358-9-191 24780 (Fax)

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