MSM specification

The MSM model can be specified in both discrete time and continuous time. [edit]Discrete

time
denote the return over two

Let denote the price of a financial asset, and let consecutive periods. In MSM, returns are specified as

where and are constants and { } are independent standard Gaussians. Volatility is driven by the first-order latent Markov state vector:

Given the volatility state , the next-period multiplier is drawn from a fixed distribution with probability , and is otherwise left unchanged.

drawn from distribution

with probability

with probability The transition probabilities are specified by . The sequence is approximately geometric at low frequency. The marginal distribution has a unit mean, has a positive support, and is independent of [edit]Binomial MSM In empirical applications, the distribution is often a discrete distribution that can take the values or with equal probability. The return process is then specified by the parameters for all . . Note that the number of parameters is the same

[edit]Continuous

time

MSM is similarly defined in continuous time. The price process follows the diffusion:

where and and

, is a standard Brownian motion, are constants. Each component follows the dynamics:

drawn from distribution

with probability

with probability

The intensities vary geometrically with

When the number of components goes to infinity, continuous-time MSM converges to a multifractal diffusion, whose sample paths take a continuum of local Hlder exponents on any finite time interval. [edit]Inference When

and closed-form likelihood

takes finitely

has a discrete distribution, the Markov state vector

many values . For instance, there are possible states in binomial MSM. The Markov dynamics are characterized by the transition matrix components volatility state, the return with . Conditional on the has Gaussian density

[edit]Conditional

distribution
. Given past returns, we

We do not directly observe the latent state vector can define the conditional probabilities:

The vector

is computed recursively:

where for any , and

The initial vector . For binomial MSM,

is set equal to the ergodic distribution of for all .

[edit]Closed-form

Likelihood

The log likelihood function has the following analytical expression:

Maximum likelihood provides reasonably precise estimates in [2] finite samples. [edit]Other

estimation methods

When has a continuous distribution, estimation can [3][4] proceed by simulated method of moments, or simulated [5] likelihood via a particle filter.

[edit]Forecasting Given , the conditional distribution of the latent state vector at date is given by:

MSM often provides better volatility forecasts than some of the best traditional models both in and out of sample. [2] Calvet and Fisher report considerable gains in exchange rate volatility forecasts at horizons of 10 to 50 days as compared with GARCH(1,1), Markov-Switching [6][7] GARCH, and Fractionally Integrated [8] [4] GARCH. Lux obtains similar results using linear predictions. [edit]Applications [edit]Multiple

assets and value-at-risk

Extensions of MSM to multiple assets provide reliable [5] estimates of the value-at-risk in a portfolio of securities. [edit]Asset

pricing

In financial economics, MSM has been used to analyze the pricing implications of multifrequency risk. The models have had some success in explaining the excess volatility of stock returns compared to fundamentals and the negative skewness of equity returns. They have also [9] been used to generate multifractal jump-diffusions. [edit]Related

approaches
[10][11]

MSM is a stochastic volatility model with arbitrarily many frequencies. MSM builds on the convenience of regime-switching models, which were advanced in [12][13] economics and finance by James D. Hamilton. MSM is closely related to the Multifractal Model of Asset [14] Returns. MSM improves on the MMARs combinatorial construction by randomizing arrival times, guaranteeing a strictly stationary process. MSM provides a pure regimeswitching formulation of multifractal measures, which [15][16][17] were pioneered by Benoit Mandelbrot. [edit]See

also

Brownian motion Markov chain Multifractal model of asset returns Multifractal Stochastic volatility

[edit]References

1.

^ Calvet, Laurent; Adlai Fisher (2001). "Forecasting multifractal volatility". Journal of Econometrics 105: 2758. doi:10.1016/S0304-4076(01)00069-0.

2.

a b c

Calvet, Laurent; Adlai Fisher (2004). "How to

Forecast long-run volatility: regime-switching and the estimation of multifractal processes". Journal of Financial Econometrics 2: 49 83.doi:10.1093/jjfinec/nbh003. 3. ^ Calvet, Laurent; Adlai Fisher (2002). Regimeswitching and the estimation of multifractal processes. 4. ^
a b

Lux, Thomas (2008). "The Markov-switching

multifractal model of asset returns: GMM estimation and linear forecasting of volatility". Journal of Business and Economic Statistics 26 (2): 194 210. doi:10.1198/073500107000000403. 5. ^
a b

Calvet, Laurent; Adlai Fisher, and Samuel

Thompson (2006). "Volatility comovement: a multifrequency approach". Journal of Econometrics 131: 179 215.doi:10.1016/j.jeconom.2005.01.008. 6. ^ Gray, Stephen (1996). "Modeling the conditional distribution of interest rates as a regime-switching process". Journal of Financial Economics 42: 27 62. doi:10.1016/0304-405X(96)00875-6. 7. ^ Klaassen, Franc (2002). "Improving GARCH volatility forecasts with regime-switching GARCH". Empirical Economics 27 (2): 363 394. doi:10.1007/s001810100100. 8. ^ Bollerslev, Tim; H. O. Mikkelsen (1996). "Modeling and pricing long memory in stock market volatility". Journal of Econometrics 73: 151 184. doi:10.1016/0304-4076(95)01736-4. 9. ^ Calvet, Laurent; Adlai Fisher (2008). "Multifractal Volatility: Theory, Forecasting and Pricing". Elsevier Academic Press.. 10. ^ Taylor, Stephen (1986). "Modelling Financial Time Series". New York: Wiley.. 11. ^ Wiggins, James (1987). "Option values under stochastic volatility: theory and empirical

estimates". Journal of Financial Economics 19 (2): 351372. doi:10.1016/0304-405X(87)90009-2. 12. ^ Hamilton, James (1989). "A new approach to the economic analysis of nonstationary time series and the business cycle". Econometrica (The Econometric Society) 57 (2): 357 84.doi:10.2307/1912559. JSTOR 1912559. 13. ^ Hamilton, James (2008). "Regime-Switching Models". New Palgrave Dictionary of Economics (2nd edition). Palgrave McMillan Ltd. 14. ^ Calvet, Laurent; Adlai Fisher and Benoit Mandelbrot (1997). "A multifractal model of asset returns". Discussion Papers , Cowles Foundation Yale University.: 11641166. 15. ^ Mandelbrot, B. (1974). "Intermittent turbulence in self-similar cascades: divergence of high moments and dimension of the carrier". Journal of Fluid Mechanics 62 (2): 331 58.doi:10.1017/S0022112074000711. 16. ^ Mandelbrot, B. (1982). "The Fractal Geometry of Nature". New York: Freeman. 17. ^ Mandelbrot, B. (1999). "Multifractals and 1/f Noise: Wild Self-Affinity in Physics". Springer.

[edit]External

links

Financial Time Series, Multifractals and Hidden Markov Models