CORRELATION ESTIMATION IN HYBRID SYSTEMS

DOI10.1142/S0219024923500085MaRDI QIDQ6095477zbMATH OpenOpenAlexFDO

Authors Baron Law

Publication date 8 September 2023

Published in International Journal of Theoretical and Applied Finance (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/2111.06042

zbMATH Keywords

correlationG2++Hestonhybrid modelpositive semidefinite matrix

Mathematics Subject Classification ID

Stochastic models in economics (91B70) Interest rates, asset pricing, etc. (stochastic models) (91G30)

Abstract: A simple method is proposed to estimate the instantaneous correlations between state variables in a hybrid system from the empirical correlations between observable market quantities such as spot rate, stock price and implied volatility. The new algorithm is extremely fast since only low-dimension linear systems are involved. If the resulting matrix from the linear systems is not positive semidefinite, the shrinking method, which requires only bisection-style iterations, is recommended to convert the matrix to positive semidefinite. The square of short-term at-the-money implied volatility is suggested as the proxy for the unobservable stochastic variance. When the implied volatility is not available, a simple trick is provided to fill in the missing correlations. Numerical study shows that the estimates are reasonably accurate, when using more than 1,000 data points. In addition, the algorithm is robust to misspecified interest rate model parameters and the short-sampling-period assumption. G2++ and Heston are used for illustration but the method can be extended to other affine term structure, local volatility and jump diffusion models, with or without stochastic interest rate.

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Cited in

(3)

• scientific article; zbMATH DE number 1780116 (Why is no real title available?)
• Bifactorial pricing models: light and shadows in correlation role
• Estimation of correlation between latent processes

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