Level Shifts in Volatility and the Implied-Realized Volatility Relation

40 Pages Posted: 17 Oct 2010

See all articles by Bent Jesper Christensen

Bent Jesper Christensen

Aarhus University; Aarhus University; Aarhus University

Paolo Santucci de Magistris

Aarhus University - CREATES

Date Written: September 10, 2010

Abstract

We propose a simple model in which realized stock market return volatility and implied volatility backed out of option prices are subject to common level shifts corresponding to movements between bull and bear markets. The model is estimated using the Kalman filter in a generalization to the multivariate case of the univariate level shift technique by Lu and Perron (2008). An application to the S&P500 index and a simulation experiment show that the recently documented empirical properties of strong persistence in volatility and forecastability of future realized volatility from current implied volatility, which have been interpreted as long memory (or fractional integration) in volatility and fractional co-integration between implied and realized volatility, are accounted for by occasional common level shifts.

Keywords: Common level shifts, fractional cointegration, fractional VECM, implied volatility, long memory, options, realized volatility

JEL Classification: C32, G13, G14, G17

Suggested Citation

Christensen, Bent Jesper and Santucci de Magistris, Paolo, Level Shifts in Volatility and the Implied-Realized Volatility Relation (September 10, 2010). Available at SSRN: https://ssrn.com/abstract=1692844 or http://dx.doi.org/10.2139/ssrn.1692844

Bent Jesper Christensen (Contact Author)

Aarhus University ( email )

Fuglesangs Alle 4
DK-8210 Aarhus V, 8210
Denmark

Aarhus University ( email )

Fuglesangs Alle 4
DK-8210 Aarhus V, 8210
Denmark

Aarhus University ( email )

Fuglesangs Alle 4
DK-8210 Aarhus V, 8210
Denmark

Paolo Santucci de Magistris

Aarhus University - CREATES ( email )

Department of Economics and Business Economics
Fuglesangs Allè 4
Aarhus V, 8210
Denmark

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