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Stochastic Volatility
In statistics, stochastic volatility models are those in which the variance of a stochastic process is itself randomly distributed. They are used in the field of mathematical finance to evaluate derivative securities, such as options. The name derives from the models' treatment of the underlying security's volatility as a random process, governed by state variables such as the price level of the underlying security, the tendency of volatility to revert to some long-run mean value, and the variance of the volatility process itself, among others. Stochastic volatility models are one approach to resolve a shortcoming of the Black–Scholes model. In particular, models based on Black-Scholes assume that the underlying volatility is constant over the life of the derivative, and unaffected by the changes in the price level of the underlying security. However, these models cannot explain long-observed features of the implied volatility surface such as volatility smile and skew, which ...
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Volatility (finance)
In finance, volatility (usually denoted by ''σ'') is the degree of variation of a trading price series over time, usually measured by the standard deviation of logarithmic returns. Historic volatility measures a time series of past market prices. Implied volatility looks forward in time, being derived from the market price of a market-traded derivative (in particular, an option). Volatility terminology Volatility as described here refers to the actual volatility, more specifically: * actual current volatility of a financial instrument for a specified period (for example 30 days or 90 days), based on historical prices over the specified period with the last observation the most recent price. * actual historical volatility which refers to the volatility of a financial instrument over a specified period but with the last observation on a date in the past **near synonymous is realized volatility, the square root of the realized variance, in turn calculated using the sum of squ ...
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Maximum Likelihood
In statistics, maximum likelihood estimation (MLE) is a method of estimation theory, estimating the Statistical parameter, parameters of an assumed probability distribution, given some observed data. This is achieved by Mathematical optimization, maximizing a likelihood function so that, under the assumed statistical model, the Realization (probability), observed data is most probable. The point estimate, point in the parameter space that maximizes the likelihood function is called the maximum likelihood estimate. The logic of maximum likelihood is both intuitive and flexible, and as such the method has become a dominant means of statistical inference. If the likelihood function is Differentiable function, differentiable, the derivative test for finding maxima can be applied. In some cases, the first-order conditions of the likelihood function can be solved analytically; for instance, the ordinary least squares estimator for a linear regression model maximizes the likelihood when ...
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Markov Switching Multifractal
In financial econometrics (the application of Statistics, statistical methods to economic data), the Markov-switching multifractal (MSM) is a model of asset returns developed by Laurent-Emmanuel Calvet, Laurent E. Calvet and Adlai J. Fisher that incorporates stochastic volatility components of Homogeneity (statistics), heterogeneous durations. MSM captures the Outliers in statistics, outliers, log-memory-like Volatility (finance), volatility persistence and power variation of financial returns. In currency and equity series, MSM compares favorably with standard Stochastic volatility, volatility models such as GARCH, GARCH(1,1) and FIGARCH both in- and out-of-sample. MSM is used by practitioners in the financial industry to forecast Volatility (finance), volatility, compute Value at risk, value-at-risk, and price Derivative (finance), derivatives. MSM specification The MSM model can be specified in both discrete time and continuous time. Discrete time Let P_t denote the price ...
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Local Volatility
A local volatility model, in mathematical finance and financial engineering, is an option pricing model that treats volatility as a function of both the current asset level S_t and of time t . As such, it is a generalisation of the Black–Scholes model, where the volatility is a constant (i.e. a trivial function of S_t and t ). Formulation In mathematical finance, the asset ''S''''t'' that underlies a financial derivative is typically assumed to follow a stochastic differential equation of the form : dS_t = (r_t-d_t) S_t\,dt + \sigma_t S_t\,dW_t , under the risk neutral measure, where r_t is the instantaneous risk free rate, giving an average local direction to the dynamics, and W_t is a Wiener process, representing the inflow of randomness into the dynamics. The amplitude of this randomness is measured by the instant volatility \sigma_t. In the simplest model i.e. the Black–Scholes model, \sigma_t is assumed to be constant; in reality, the realised volatility of an unde ...
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Heston Model
In finance, the Heston model, named after Steven L. Heston, is a mathematical model that describes the evolution of the volatility of an underlying asset. It is a stochastic volatility model: such a model assumes that the volatility of the asset is not constant, nor even deterministic, but follows a random process. Basic Heston model The basic Heston model assumes that ''St'', the price of the asset, is determined by a stochastic process, : dS_t = \mu S_t\,dt + \sqrt S_t\,dW^S_t, where \nu_t, the instantaneous variance, is given by a Feller square-root or CIR process, : d\nu_t = \kappa(\theta - \nu_t)\,dt + \xi \sqrt\,dW^_t, and W^S_t, W^_t are Wiener processes (i.e., continuous random walks) with correlation ρ. The model has five parameters: * \nu_0, the initial variance. * \theta, the long variance, or long-run average variance of the price; as ''t'' tends to infinity, the expected value of ν''t'' tends to θ. * \rho, the correlation of the two Wiener processes. * \ ...
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Markov Chain Monte Carlo
In statistics, Markov chain Monte Carlo (MCMC) methods comprise a class of algorithms for sampling from a probability distribution. By constructing a Markov chain that has the desired distribution as its equilibrium distribution, one can obtain a sample of the desired distribution by recording states from the chain. The more steps that are included, the more closely the distribution of the sample matches the actual desired distribution. Various algorithms exist for constructing chains, including the Metropolis–Hastings algorithm. Application domains MCMC methods are primarily used for calculating numerical approximations of multi-dimensional integrals, for example in Bayesian statistics, computational physics, computational biology and computational linguistics. In Bayesian statistics, the recent development of MCMC methods has made it possible to compute large hierarchical models that require integrations over hundreds to thousands of unknown parameters. In rare even ...
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R (programming Language)
R is a programming language for statistical computing and graphics supported by the R Core Team and the R Foundation for Statistical Computing. Created by statisticians Ross Ihaka and Robert Gentleman, R is used among data miners, bioinformaticians and statisticians for data analysis and developing statistical software. Users have created packages to augment the functions of the R language. According to user surveys and studies of scholarly literature databases, R is one of the most commonly used programming languages used in data mining. R ranks 12th in the TIOBE index, a measure of programming language popularity, in which the language peaked in 8th place in August 2020. The official R software environment is an open-source free software environment within the GNU package, available under the GNU General Public License. It is written primarily in C, Fortran, and R itself (partially self-hosting). Precompiled executables are provided for various operating systems. R ...
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Directed Set
In mathematics, a directed set (or a directed preorder or a filtered set) is a nonempty set A together with a reflexive and transitive binary relation \,\leq\, (that is, a preorder), with the additional property that every pair of elements has an upper bound. In other words, for any a and b in A there must exist c in A with a \leq c and b \leq c. A directed set's preorder is called a . The notion defined above is sometimes called an . A is defined analogously, meaning that every pair of elements is bounded below. Some authors (and this article) assume that a directed set is directed upward, unless otherwise stated. Other authors call a set directed if and only if it is directed both upward and downward. Directed sets are a generalization of nonempty totally ordered sets. That is, all totally ordered sets are directed sets (contrast ordered sets, which need not be directed). Join-semilattices (which are partially ordered sets) are directed sets as well, but not conversely. ...
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Maximum Likelihood
In statistics, maximum likelihood estimation (MLE) is a method of estimation theory, estimating the Statistical parameter, parameters of an assumed probability distribution, given some observed data. This is achieved by Mathematical optimization, maximizing a likelihood function so that, under the assumed statistical model, the Realization (probability), observed data is most probable. The point estimate, point in the parameter space that maximizes the likelihood function is called the maximum likelihood estimate. The logic of maximum likelihood is both intuitive and flexible, and as such the method has become a dominant means of statistical inference. If the likelihood function is Differentiable function, differentiable, the derivative test for finding maxima can be applied. In some cases, the first-order conditions of the likelihood function can be solved analytically; for instance, the ordinary least squares estimator for a linear regression model maximizes the likelihood when ...
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GARCH
In econometrics, the autoregressive conditional heteroskedasticity (ARCH) model is a statistical model for time series data that describes the variance of the current error term or innovation as a function of the actual sizes of the previous time periods' error terms; often the variance is related to the squares of the previous innovations. The ARCH model is appropriate when the error variance in a time series follows an autoregressive (AR) model; if an autoregressive moving average (ARMA) model is assumed for the error variance, the model is a generalized autoregressive conditional heteroskedasticity (GARCH) model. ARCH models are commonly employed in modeling financial time series that exhibit time-varying volatility and volatility clustering, i.e. periods of swings interspersed with periods of relative calm. ARCH-type models are sometimes considered to be in the family of stochastic volatility models, although this is strictly incorrect since at time ''t'' the volatility is co ...
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Local Volatility
A local volatility model, in mathematical finance and financial engineering, is an option pricing model that treats volatility as a function of both the current asset level S_t and of time t . As such, it is a generalisation of the Black–Scholes model, where the volatility is a constant (i.e. a trivial function of S_t and t ). Formulation In mathematical finance, the asset ''S''''t'' that underlies a financial derivative is typically assumed to follow a stochastic differential equation of the form : dS_t = (r_t-d_t) S_t\,dt + \sigma_t S_t\,dW_t , under the risk neutral measure, where r_t is the instantaneous risk free rate, giving an average local direction to the dynamics, and W_t is a Wiener process, representing the inflow of randomness into the dynamics. The amplitude of this randomness is measured by the instant volatility \sigma_t. In the simplest model i.e. the Black–Scholes model, \sigma_t is assumed to be constant; in reality, the realised volatility of an unde ...
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Correlation
In statistics, correlation or dependence is any statistical relationship, whether causal or not, between two random variables or bivariate data. Although in the broadest sense, "correlation" may indicate any type of association, in statistics it usually refers to the degree to which a pair of variables are ''linearly'' related. Familiar examples of dependent phenomena include the correlation between the height of parents and their offspring, and the correlation between the price of a good and the quantity the consumers are willing to purchase, as it is depicted in the so-called demand curve. Correlations are useful because they can indicate a predictive relationship that can be exploited in practice. For example, an electrical utility may produce less power on a mild day based on the correlation between electricity demand and weather. In this example, there is a causal relationship, because extreme weather causes people to use more electricity for heating or cooling. However ...
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