Rough Volatility: Fact or Artefact?

Rama Cont, Purba Das*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

5 Citations (Scopus)

Abstract

We investigate the statistical evidence for the use of ‘rough’ fractional processes with Hurst exponent H<0.5 for modeling the volatility of financial assets, using a model-free approach. We introduce a non-parametric method for estimating the roughness of a function based on discrete sample, using the concept of normalized p-th variation along a sequence of partitions. Detailed numerical experiments based on sample paths of fractional Brownian motion and other fractional processes reveal good finite sample performance of our estimator for measuring the roughness of sample paths of stochastic processes. We then apply this method to estimate the roughness of realized volatility signals based on high-frequency observations. Detailed numerical experiments based on stochastic volatility models show that, even when the instantaneous volatility has diffusive dynamics with the same roughness as Brownian motion, the realized volatility exhibits rough behaviour corresponding to a Hurst exponent significantly smaller than 0.5. Comparison of roughness estimates for realized and instantaneous volatility in fractional volatility models with different values of Hurst exponent shows that, irrespective of the roughness of the spot volatility process, realized volatility always exhibits ‘rough’ behaviour with an apparent Hurst index H^<0.5. These results suggest that the origin of the roughness observed in realized volatility time series lies in the estimation error rather than the volatility process itself.

Original languageEnglish
Pages (from-to)191-223
Number of pages33
JournalSankhya B
Volume86
Issue number1
Early online date21 Feb 2024
DOIs
Publication statusPublished - May 2024

Keywords

  • 62G10
  • 62M07
  • 62P05
  • fractional Brownian motion
  • high-frequency data
  • hurst exponent
  • instantaneous volatility
  • p-th variation
  • Primary 60L90
  • realized volatility
  • Roughness
  • Secondary 60G22
  • variation index

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