Boston College Finance Dept. Working Paper
31 Pages Posted: 16 Jul 2001
Date Written: May 2001
The basic univariate stochastic volatility model specifies that conditional volatility follows a log-normal auto-regressive model with innovations assumed to be independent of the innovations in the conditional mean equation. Since the introduction of practical methods for inference in the basic volatility model (JPR-(1994)), it has been observed that the basic model is too restrictive for many financial series. We extend the basic SVOL to allow for a so-called "Leverage effect" via correlation between the volatility and mean innovations, and for fat-tails in the mean equation innovation. A Bayesian Markov Chain Monte Carlo algorithm is developed for the extended volatility model. Thus far, likelihood-based inference for the correlated SVOL model has not appeared in the literature. We develop Bayes Factors to assess the importance of the leverage and fat-tail extensions. Sampling experiments reveal little loss in precision from adding the model extensions but a large loss from using the basic model in the presence of mis-specification. For both equity and exchange rate data, there is overwhelming evidence in favor of models with fat-tailed volatility innovations, and for a leverage effect in the case of equity indices. We also find that volatility estimates from the extended model are markedly different from those produced by the basic SVOL.
Keywords: ARCH, Bayes factor, Fat-tails, Gibbs Leverage effect, Metropolis, MCMC, Stochastic volatility
JEL Classification: C1, C11, C15, G1
Suggested Citation: Suggested Citation
Jacquier, Eric and Rossi , Peter E. and Polson, Nick, Bayesian Analysis of a Stochastic Volatility Model with Leverage Effect and Fat Tails (May 2001). Boston College Finance Dept. Working Paper. Available at SSRN: https://ssrn.com/abstract=275500 or http://dx.doi.org/10.2139/ssrn.275500