Stochastic Volatility.

Working paper

Stochastic volatility (SV) is the main concept used in the elds of nancial economics and mathematical nance to deal with the endemic time-varying volatility and codependence found in nancial markets. Such dependence has been known for a long time. It was also clear to the founding fathers of modern continuous time nance that homogeneity was an unrealistic if convenient simplication. Heterogeneity has deep implications for the theory and practice of nancial economics and econometrics. In particular, asset pricing theory is dominated by the idea that higher rewards may be expected when we face higher risks, but these risks change through time in complicated ways. Some of the changes in the level of risk can be modelled stochastically, where the level of volatility and degree of codependence between assets is allowed to change over time. Such models allow us to explain, for example, empirically observed departures from Black-Scholes-Merton prices for options and understand why we should expect to see occasional dramatic moves in financial markets.

Authors: Shephard, N

• Publisher: Nuffield College (University of Oxford)
• Host title: Economics Group, Nuffield College, University of Oxford, Economics Papers
• Series: Economics Working Papers
• Publication date: 2005-01-01
• Language: English