Modelling Stochastic Volatility with Leverage and Jumps: A Simulated Maximum Likelihood Approach via Particle Filtering

53 Pages Posted: 21 Feb 2011

Date Written: February 1, 2011

Abstract

In this paper we provide a unified methodology for conducting likelihood-based inference on the unknown parameters of a general class of discrete-time stochastic volatility (SV) models, characterized by both a leverage effect and jumps in returns. Given the nonlinear/non-Gaussian state-space form, approximating the likelihood for the parameters is conducted with output generated by the particle filter. Methods are employed to ensure that the approximating likelihood is continuous as a function of the unknown parameters thus enabling the use of standard Newton-Raphson type maximization algorithms. Our approach is robust and efficient relative to alternative Markov Chain Monte Carlo schemes employed in such contexts. In addition it provides a feasible basis for undertaking the nontrivial task of model comparison. Furthermore, we introduce new volatility model, namely SV-GARCH which attempts to bridge the gap between GARCH and stochastic volatility specifications. In nesting the standard GARCH model as a special case, it has the attractive feature of inheriting the same unconditional properties of the standard GARCH model but being conditionally heavier-tailed; thus more robust to outliers. It is demonstrated how this model can be estimated using the described methodology. The technique is applied to daily returns data for S&P 500 stock price index for various spans. In assessing the relative performance of SV with leverage and jumps and nested specifications, we find strong evidence in favour of a including leverage effect and jumps when modelling stochastic volatility. Additionally, we find very encouraging results for SV-GARCH in terms of predictive ability which is comparable to the other models considered.

Keywords: Stochastic Volatility, Particle Filter, Simulation, State Space, Leverage Effect, Jumps

JEL Classification: C01, C11, C14, C15, C32, E32

Suggested Citation

Malik, Sheheryar and Pitt, Michael K., Modelling Stochastic Volatility with Leverage and Jumps: A Simulated Maximum Likelihood Approach via Particle Filtering (February 1, 2011). Available at SSRN: https://ssrn.com/abstract=1763783 or http://dx.doi.org/10.2139/ssrn.1763783

Sheheryar Malik (Contact Author)

Banque de France ( email )

Paris
France

Michael K. Pitt

University of Warwick ( email )

Gibbet Hill Rd.
Coventry, West Midlands CV4 8UW
United Kingdom

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