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Market-based estimation of stochastic volatility models

Author(s): Ait-Sahalia, Yacine; Amengual, Dante; Manresa, Elena

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Abstract: We propose a method for estimating stochastic volatility models by adapting the HJM approach to the case of volatility derivatives. We characterize restrictions that observed variance swap dynamics have to satisfy to prevent arbitrage opportunities. When the drift of variance swap rates are affine under the pricing measure, we obtain closed form expressions for those restrictions and formulae for forward variance curves. Using data on the S&P 500 index and variance swap rates on different time to maturities, we find that linear mean-reverting one factor models provide inaccurate representation of the dynamics of the variance swap rates while two-factor models significantly outperform the former both in and out of sample.
Publication Date: Aug-2015
Citation: Ait-Sahalia, Yacine, Amengual, Dante, Manresa, Elena. (2015). Market-based estimation of stochastic volatility models. Journal of Econometrics, 187 (2), 418 - 435. doi:10.1016/j.jeconom.2015.02.028
DOI: doi:10.1016/j.jeconom.2015.02.028
ISSN: 0304-4076
Pages: 418 - 435
Type of Material: Journal Article
Journal/Proceeding Title: Journal of Econometrics
Version: Author's manuscript

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