Markov Switching GARCH Diffusion

Carol Alexander and Emese Lazar

ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading

Abstract: GARCH option pricing models have the advantage of a well-established econometric foundation. However, multiple states need to be introduced as single state GARCH and even Levy processes are unable to explain the term structure of the moments of financial data. We show that the continuous time version of the Markov switching GARCH(1,1) process is a stochastic model where the volatility follows a switching process. The continuous time switching GARCH model derived in this paper, where the variance process jumps between two or more GARCH volatility states, is able to capture the features of implied volatilities in an intuitive and tractable framework.

Keywords: GARCH; jumps; normal mixture; Markov switching; stochastic volatility; time aggregation (search for similar items in EconPapers)
JEL-codes: C32 G13 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2008-03
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Citations: View citations in EconPapers (2)

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