A New Approach to Volatility Modeling: The High-Dimensional Markov Model

CRREP working serie 2016-09

50 Pages Posted: 30 Mar 2018 Last revised: 25 Apr 2018

See all articles by Maciej Augustyniak

Maciej Augustyniak

University of Montreal - Department of Mathematics and Statistics

Arnaud Dufays

CeReFiM. Université de Namur.; Université Laval

Luc Bauwens

Université catholique de Louvain

Date Written: December 1, 2016

Abstract

A new model - the factorial hidden Markov volatility (FHMV) model - is proposed for financial returns and their latent variances. It is also applicable to model directly realized variances. Volatility is modeled as a product of three components: a Markov chain driving volatility persistence, an independent discrete process capable of generating jumps in the volatility, and a predictable (data-driven) process capturing the leverage effect. An economic interpretation is attached to each one of these components. Moreover, the Markov chain and jump components allow volatility to switch abruptly between thousands of states, and the transition matrix of the model is structured in such a way as to generate a high degree of volatility persistence. In-sample results on six financial time series highlight that the FHMV process compares favorably to state-of-the-art volatility models. A forecasting experiment shows that it also outperforms its competitors when predicting volatility over time horizons ranging from one to one hundred days.

Keywords: Volatility, Markov-switching, Persistence, Leverage effect

JEL Classification: C22, C51, C58

Suggested Citation

Augustyniak, Maciej and Dufays, Arnaud and Bauwens, Luc, A New Approach to Volatility Modeling: The High-Dimensional Markov Model (December 1, 2016). CRREP working serie 2016-09, Available at SSRN: https://ssrn.com/abstract=3149098 or http://dx.doi.org/10.2139/ssrn.3149098

Maciej Augustyniak

University of Montreal - Department of Mathematics and Statistics ( email )

C.P. 6128, succursale Centre-ville
Montreal, Quebec H3C 3J7
Canada

HOME PAGE: http://dms.umontreal.ca/

Arnaud Dufays (Contact Author)

CeReFiM. Université de Namur. ( email )

Rempart de la Vierge 8
Namur, Namur 5000
Belgium

Université Laval ( email )

2214 Pavillon J-A. DeSeve
Quebec, Quebec G1K 7P4
Canada

Luc Bauwens

Université catholique de Louvain ( email )

CORE
34 Voie du Roman Pays
B-1348 Louvain-la-Neuve, b-1348
Belgium
32 10 474321 (Phone)
32 10 474301 (Fax)

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