Level Shifts in Volatility and the Implied-Realized Volatility Relation

Bent Jesper Christensen and Paolo Santucci de Magistris ()
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Paolo Santucci de Magistris: University of Pavia and CREATES, Postal: Dipartimento di Economia Politica e Metodi Quantitativi, University of Pavia, Italy

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: We propose a simple model in which realized stock market return volatility and implied volatility backed out of option prices are subject to common level shifts corresponding to movements between bull and bear markets. The model is estimated using the Kalman filter in a generalization to the multivariate case of the univariate level shift technique by Lu and Perron (2008). An application to the S&P500 index and a simulation experiment show that the recently documented empirical properties of strong persistence in volatility and forecastability of future realized volatility from current implied volatility, which have been interpreted as long memory (or fractional integration) in volatility and fractional cointegration between implied and realized volatility, are accounted for by occasional common level shifts.

Keywords: Common level shifts; fractional cointegration; fractional VECM; implied volatility; long memory; options; realized volatility. (search for similar items in EconPapers)
JEL-codes: C32 G13 G14 G17 (search for similar items in EconPapers)
Pages: 38
Date: 2010-09-09
New Economics Papers: this item is included in nep-bec, nep-ecm, nep-ets, nep-fmk and nep-for
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Citations: View citations in EconPapers (7)

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