A novel approach to forecasting financial volatility with Gaussian process envelopes

Journal article

In this paper we use Gaussian Process (GP) regression to propose a novel approach for predicting volatility of financial returns by forecasting the envelopes of the time series. We provide a direct com- parison of their performance to traditional approaches such as GARCH. We compare the forecasting power of three approaches: GP regression on the absolute and squared returns; regression on the envelope of the returns and the absolute returns; and regression on the envelope of the negative and positive returns separately. We use a maximum a posteri- ori estimate with a Gaussian prior to determine our hyperparameters. We also test the effect of hyperparameter updating at each forecasting step. We use our approaches to forecast out-of-sample volatility of four currency pairs over a 2 year period, at half-hourly intervals. From three kernels, we select the kernel giving the best performance for our data.We use two published accuracy measures and four statistical loss functions to evaluate the forecasting ability of GARCH vs GPs. In mean squared error the GP’s perform 20% better than a random walk model, and 50% better than GARCH for the same data.

Authors: Rizvi, S; Roberts, S; Osborne, M; Nyikosa, F

• Publication status: Not published
• Peer review status: Not peer reviewed
• Publisher: Cornell University
• Journal: arXiv
• Publication date: 2017-05-02