Alternative models for stock price dynamics
Abstract
This paper evaluates the role of various volatility specifications, such as multiple
stochastic volatility (SV) factors and jump components, in appropriate modeling of
equity return distributions. We use estimation technology that facilitates nonnested
model comparisons and use a long data set which provides rich information about the
conditional and unconditional distribution of returns. We consider two broad families
of models: (1) the multifactor loglinear family, and (2) the affine-jump family. Both
classes of models have attracted much attention in the derivatives and econometrics
literatures. There are various tradeoffs in considering such diverse specifications.
If pure diffusion SV models are chosen over jump diffusions, it has important implications
for hedging strategies. If logarithmic models are chosen over affine ones, it may
seriously complicate option pricing. Comparing many different specifications of pure
diffusion multifactor models and jump diffusion models, we find that (1) log linear
models have to be extended to two factors with feedback in the mean reverting factor,
(2) affine models have to have a jump in returns, stochastic volatility or probably
both. Models (1) and (2) are observationally equivalent on the data set in hand. In
either (1) or (2) the key is that the volatility can move violently. As we obtain
models with comparable empirical fit, one must make a choice based on arguments other
than statistical goodness-of-fit criteria. The considerations include facility to
price options, to hedge and parsimony. The affine specification with jumps in volatility
might therefore be preferred because of the closed-form derivatives prices. © 2003
Elsevier B.V. All rights reserved.
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Journal articlePermalink
https://hdl.handle.net/10161/1892Published Version (Please cite this version)
10.1016/S0304-4076(03)00108-8Publication Info
Tauchen, G; Chernov, M; Gallant, AR; & Ghysels, E (2003). Alternative models for stock price dynamics. Journal of Econometrics, 116(1-2). pp. 225-257. 10.1016/S0304-4076(03)00108-8. Retrieved from https://hdl.handle.net/10161/1892.This is constructed from limited available data and may be imprecise. To cite this
article, please review & use the official citation provided by the journal.
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