Volatility Bursts: A Discrete-time Option Model with Multiple Volatility Components

50 Pages Posted: 22 Jul 2021

Date Written: June 22, 2021

Abstract

I propose an affine discrete-time model, called Vector Autoregressive Gamma with volatility Bursts (VARG-B) in which volatility experiences, in addition to frequent and small changes, periods of sudden and extreme movements generated by a latent factor which evolves according to the Autoregressive Gamma Zero process. A key advantage of the discrete-time specification is that it makes it possible to estimate the model via the Extended Kalman Filter. Moreover, the VARG-B model leads to a fully analytic conditional Laplace transform, resulting in a closed-form option pricing formula. When estimated on S&P500 index options and returns the new model provides more accurate option pricing and modelling of the IV surface compared with some alternative models.

Keywords: volatility bursts, ARG-zero, option pricing, Kalman filter, realized volatility

JEL Classification: C13, G12, G13

Suggested Citation

Lilla, Francesca, Volatility Bursts: A Discrete-time Option Model with Multiple Volatility Components (June 22, 2021). Bank of Italy Temi di Discussione (Working Paper) No. 1336, Available at SSRN: https://ssrn.com/abstract=3891561 or http://dx.doi.org/10.2139/ssrn.3891561

Francesca Lilla (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

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