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Generalized Mean-Reverting 4/2 Factor Model

Yuyang Cheng (), Marcos Escobar-Anel () and Zhenxian Gong ()
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Yuyang Cheng: Department of Statistical and Actuarial Sciences, Western University, London, ON N6A 3K7, Canada
Marcos Escobar-Anel: Department of Statistical and Actuarial Sciences, Western University, London, ON N6A 3K7, Canada
Zhenxian Gong: Department of Statistical and Actuarial Sciences, Western University, London, ON N6A 3K7, Canada

Authors registered in the RePEc Author Service: Marcos Escobar Anel ()

Journal of Risk and Financial Management, 2019, vol. 12, issue 4, 1-21

Abstract: This paper proposes and investigates a multivariate 4/2 Factor Model. The name 4/2 comes from the superposition of a CIR term and a 3/2-model component. Our model goes multidimensional along the lines of a principal component and factor covariance decomposition. We find conditions for well-defined changes of measure and we also find two key characteristic functions in closed-form, which help with pricing and risk measure calculations. In a numerical example, we demonstrate the significant impact of the newly added 3/2 component (parameter b ) and the common factor ( a ), both with respect to changes on the implied volatility surface (up to 100%) and on two risk measures: value at risk and expected shortfall where an increase of up to 29% was detected.

Keywords: stochastic covariance; 4/2 model; option pricing; risk measures (search for similar items in EconPapers)
JEL-codes: C E F2 F3 G (search for similar items in EconPapers)
Date: 2019
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