Stochastic volatility

Stochastic volatility (SV) is the main concept used in the fields of financial economics and mathematical finance to deal with the endemic time-varying volatility and codependence found in financial markets. Such dependence has been known for a long time, early comments include Mandelbrot (1963) and Officer (1973). It was also clear to the founding fathers of modern continuous time finance that homogeneity was an unrealistic if convenient simplification, e.g. Black and Scholes (1972, p. 416) wrote “... there is evidence of non-stationarity in the variance. More work must be done to predict variances using the information available.” Heterogeneity has deep implications for the theory and practice of financial 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. The outline of this article is as follows. In section 2 I will trace the origins of SV and provide links with the basic models used today in the literature. In section 3 I will briefly discuss some of the innovations in the second generation of SV models. In section 4 I will briefly discuss the literature on conducting inference for SV models. In section 5 I will talk about the use of SV to price options. In section 6 I will consider the connection of SV with realised volatility. A extensive reviews of this literature is given in Shephard (2005).