Volatility Bursts: A discrete-time option model with multiple volatility components

Francesca Lilla ()

No 1336, Temi di discussione (Economic working papers) from Bank of Italy, Economic Research and International Relations Area

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 (search for similar items in EconPapers)
JEL-codes: C13 G12 G13 (search for similar items in EconPapers)
Date: 2021-06
New Economics Papers: this item is included in nep-ecm, nep-ets and nep-ore
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