Inverse Realized Laplace Transforms for Nonparametric Volatility Estimation in Jump-Diffusions

31 Pages Posted: 12 Oct 2011

Date Written: September 27, 2011

Abstract

We develop a nonparametric estimator of the stochastic volatility density of a discretely-observed Ito semimartingale in the setting of an increasing time span and finer mesh of the observation grid. There are two steps. The first is aggregating the high-frequency increments into the realized Laplace transform, which is a robust nonparametric estimate of the underlying volatility Laplace transform. The second step is using a regularized kernel to invert the realized Laplace transform. The two steps are relatively quick and easy to compute, so the nonparametric estimator is practicable. We derive bounds for the mean squared error of the estimator. The regularity conditions are sufficiently general to cover empirically important cases such as level jumps and possible dependencies between volatility moves and either diffusive or jump moves in the semimartingale. Monte Carlo work indicates that the nonparametric estimator is reliable and reasonably accurate in realistic estimation contexts. An empirical application to 5-minute data for three large-cap stocks, 1997-2010, reveals the importance of big short-term volatility spikes in generating high levels of stock price variability over and above that induced by price jumps. The application also shows how to trace out the dynamic response of the volatility density to both positive and negative jumps in the stock price.

Keywords: Laplace transform, stochastic volatility, ill-posed problems, regularization, nonparametric density estimation, high-frequency data

JEL Classification: C51, C52, G12

Suggested Citation

Todorov, Viktor and Tauchen, George E., Inverse Realized Laplace Transforms for Nonparametric Volatility Estimation in Jump-Diffusions (September 27, 2011). Economic Research Initiatives at Duke (ERID) Working Paper No. 112, Available at SSRN: https://ssrn.com/abstract=1943061 or http://dx.doi.org/10.2139/ssrn.1943061

Viktor Todorov

Northwestern University ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

George E. Tauchen (Contact Author)

Duke University - Economics Group ( email )

Box 90097
221 Social Sciences
Durham, NC 27708-0097
United States
919-660-1812 (Phone)
919-684-8974 (Fax)

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