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Calibrating the exponential Ornstein--Uhlenbeck multiscale stochastic volatility model

Cyrille Dubarry and Randal Douc

Quantitative Finance, 2014, vol. 14, issue 3, 443-456

Abstract: This paper demonstrates a tractable and efficient way of calibrating a multiscale exponential Ornstein--Uhlenbeck stochastic volatility model including a correlation between the asset return and its volatility. As opposed to many contributions where this correlation is assumed to be null, this framework allows one to describe the leverage effect widely observed in equity markets. The resulting model is non-exponential and driven by a degenerate noise, thus requiring a high level of care in designing the estimation algorithm. The way this difficulty is overcome provides guidelines concerning the development of an estimation algorithm in a non-standard framework. The authors propose using a block-type expectation maximization algorithm along with particle smoothing. This method results in an accurate calibration process able to identify up to three timescale factors. Furthermore, we introduce an intuitive heuristic which can be used to choose the number of factors.

Date: 2014
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