Volatility Forecasting and Explanatory Variables: A Tractable Bayesian Approach to Stochastic Volatility
University of Montreal
May 23, 2013
We provide a formulation of stochastic volatility (SV) based on Gaussian process regression (GPR). Forecasting volatility out-of-sample, both simulation and empirical analyses show that our GPR-based stochastic volatility (GPSV) model clearly outperforms SV and GARCH benchmarks, especially at long horizons. Most importantly, our approach enables the straightforward incorporation of arbitrary covariates without requiring the specification of functional forms a priori. Augmenting the GPSV model with exogenous variables increases its performance even further. In particular, a simple set of covariates reduces the error rate on one-year out-of-sample forecasting during the 2007-09 recession by 26% relative to a benchmark range-based SV model.
Number of Pages in PDF File: 47
Keywords: Bayesian Volatility Models, Stochastic Volatility, Generalized Autoregressive Conditional Heteroscedasticity Models, Long Memory in Volatility, Multifactor Volatility
JEL Classification: C11, C22, C53
Date posted: January 26, 2011 ; Last revised: May 23, 2013