Probability distribution of returns in the exponential Ornstein-Uhlenbeck model

Giacomo Bormetti, Valentina Cazzola, Guido Montagna and Oreste Nicrosini

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Abstract: We analyze the problem of the analytical characterization of the probability distribution of financial returns in the exponential Ornstein-Uhlenbeck model with stochastic volatility. In this model the prices are driven by a Geometric Brownian motion, whose diffusion coefficient is expressed through an exponential function of an hidden variable Y governed by a mean-reverting process. We derive closed-form expressions for the probability distribution and its characteristic function in two limit cases. In the first one the fluctuations of Y are larger than the volatility normal level, while the second one corresponds to the assumption of a small stationary value for the variance of Y. Theoretical results are tested numerically by intensive use of Monte Carlo simulations. The effectiveness of the analytical predictions is checked via a careful analysis of the parameters involved in the numerical implementation of the Euler-Maruyama scheme and is tested on a data set of financial indexes. In particular, we discuss results for the German DAX30 and Dow Jones Euro Stoxx 50, finding a good agreement between the empirical data and the theoretical description.

Date: 2008-05, Revised 2008-10
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Citations: View citations in EconPapers (2)

Published in J. Stat. Mech. (2008) P11013

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