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A GARCH model with two volatility components and two driving factors

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  • Luca Vincenzo Ballestra
  • Enzo D'Innocenzo
  • Christian Tezza

Abstract

We introduce a novel GARCH model that integrates two sources of uncertainty to better capture the rich, multi-component dynamics often observed in the volatility of financial assets. This model provides a quasi closed-form representation of the characteristic function for future log-returns, from which semi-analytical formulas for option pricing can be derived. A theoretical analysis is conducted to establish sufficient conditions for strict stationarity and geometric ergodicity, while also obtaining the continuous-time diffusion limit of the model. Empirical evaluations, conducted both in-sample and out-of-sample using S\&P500 time series data, show that our model outperforms widely used single-factor models in predicting returns and option prices.

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  • Luca Vincenzo Ballestra & Enzo D'Innocenzo & Christian Tezza, 2024. "A GARCH model with two volatility components and two driving factors," Papers 2410.14585, arXiv.org.
  • Handle: RePEc:arx:papers:2410.14585
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