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Electronic copy available at: http://ssrn.

com/abstract=1054721
ISSN 1283-0623
L

EONARD DE VINCI
Estimating the Wishart Ane Stochastic
Correlation Model using the Empirical
Characteristic Function
Jose Da Fonseca Martino Grasselli Florian Ielpo
11-2007
ESILV, DER-MIF, No RR-35
Electronic copy available at: http://ssrn.com/abstract=1054721
Estimating the Wishart Ane Stochastic
Correlation Model using the Empirical
Characteristic Function

Jose Da Fonseca

Martino Grasselli

Florian Ielpo

First draft: November 27


th
, 2007
This draft: March 5
th
, 2008
Abstract
In this paper, we present and discuss the estimation of the Wishart Ane
Stochastic Correlation (WASC) model introduced in Da Fonseca et al.
(2006) under the historical measure. We review the main estimation pos-
sibilities for this continuous time process and provide elements to show
that the utilization of empirical characteristic function-based estimates is
advisable as this function is exponential ane in the WASC case. We
thus propose to use the estimation strategy closed to the ones developed in
Chacko and Viceira (2003) and Carrasco et al. (2007). We use a continuum
of moment conditions based on the characteristic function obtained when
the co-volatility process has been integrated out. We investigate the behav-
ior of the estimates through Monte Carlo simulations. Then, we present
the estimation results obtained using a dataset of equity indexes: SP500,
FTSE, DAX and CAC. On the basis of these results, we show that the
WASC captures many of the known stylized facts associated with nan-
cial markets, including the negative correlation between stock returns and
volatility. It also helps reveal interesting patterns in the studied indexes
covariances and their correlation dynamics.
Keywords: Wishart Process, Empirical Characteristic Function, Stochastic Cor-
relation, Generalized Method of Moments.

Acknowledgements: We are particularly indebted to Marine Carrasco for remarkable in-


sights and helpful comments. We are also grateful to Fulvio Pegoraro and Francois-Xavier
Vialard for helpful remarks. Any errors remain ours.

Ecole Superieure dIngenieurs Leonard de Vinci, Departement Mathematiques et Ingenierie


Financi`ere, 92916 Paris La Defense, France. Email: jose.da fonseca@devinci.fr and Zeliade
Systems, 56, Rue Jean-Jacques Rousseau, 75001 Paris.

Universit`a degli Studi di Padova , Dipartimento di Matematica Pura ed Applicata, Via


Trieste 63, Padova, Italy.E-mail: grassell @math.unipd.it and ESILV.

Centre dEconomie de la Sorbonne, 106 Boulevard de lHopital, 75013 Paris, France. E-


mail: ielpo@ces.ens-cachan.fr. Dexia S.A., Passerelle des Reets, La Defense, France.
1
1 Introduction
The estimation of continuous time processes under the physical measure attracted
a lot of attention over the few past years, and several estimation strategies have
been proposed in the literature. When the transition density is known in closed
form, it is possible to perform a maximum likelihood estimation of the diusion
parameters, as presented e.g. in Lo (1988). However, the number of models for
which the transition density is known in a closed form expression is somewhat
limited. Moreover, the existence of unobservable factors such as the volatility
process in the Heston (1993) model makes it dicult if not impossible to
estimate such models using a conditional maximum likelihood approach. A pos-
sible solution consists in discretizing and simulating the unobservable process: for
example, Due and Singleton (1993) used the Simulated Methods of Moments
to estimate nancial Markov processes (methods of this kind are reviewed in
Gourieroux and Monfort, 1996). However, as pointed out in Chacko and Viceira
(2003), even though these methods are straightforward to apply, it is dicult
to measure the numerical errors due to the discretization. What is more, the
computational burden of this class of methods precludes its use for multivariate
processes.
For the special class of ane models, another estimation strategy can be used.
The ane models present tractable exponentially ane characteristic functions
that can in turn be used to estimate the parameters under the historical measure.
Singleton (2001) and Singleton (2006) present a list of possible estimation strate-
gies that can be applied to recover these parameters from nancial time series,
using the characteristic function of the process. Methodologies of this kind have
been applied to one-dimensional processes, like the Cox-Ingersoll-Ross process
(e.g. Zhou, 2000), the Heston process and a mixture of stochastic volatility and
jump processes (e.g. Jiang and Knight, 2002, Rockinger and Semenova, 2005 and
Chacko and Viceira, 2003), ane jump diusion models (e.g. Yu, 2004), yielding
interesting results. Still, it involves additional diculties. First, as remarked
in Jiang and Knight (2002) and Rockinger and Semenova (2005), numerically
integrating the characteristic function of a vector of the state variable is com-
putationally intensive. In our multivariate case the state variable is already a
vector: for this type of methodology, the integral discretization is likely to lead to
numerical errors. Second, with the Spectral GMM method presented in Chacko
and Viceira (2003), the use of a more limited number of points of the character-
istic function settles the numerical problem, but leads to a decrease in estimates
eciency. Carrasco and Florens (2000) and Carrasco et al. (2007) present a
method that uses a continuum of moment conditions built from the character-
istic function. With this method, the estimates obtained reach the eciency of
the maximum likelihood method, thanks to the instrument used in this strategy.
These features make this methodology particularly well-suited for the estimation
of ane multivariate continuous time processes.
Here, we propose to use a Spectral Generalized Method of Moments estimation
2
strategy to estimate the Wishart Ane Stochastic Correlation model, an ane
multivariate stochastic volatility and correlation model introduced in Da Fonseca
et al. (2006). Based on the previous models of Gourieroux and Sufana (2004) and
Buraschi et al. (2006), this ane model can be regarded as a multivariate version
of the Heston (1993) model: in fact, the volatility matrix is assumed to evolve
according to the Wishart dynamics (mathematically developed by Bru, 1991),
the matrix analogue of the mean reverting square root process. In addition to
the Heston model, it allows for a stochastic conditional correlation, which makes
it very promising process for nancial applications.
Multivariate stochastic volatility models have recently attracted a great deal of
attention. Asai et al. (2006) present a survey of the existing models, along with
estimation methodologies. When compared to the previously mentioned pro-
cesses, several important dierences must be underlined. (1) The volatility being
a latent factor, the observable state variable (the asset log returns) is not Markov,
thus the ML eciency cannot be reach. (2) What is more, as we discuss it in the
paper, since the process involves latent volatilities and correlations, the instru-
ment must be set to be equal to one for the usual GMM methodology to be used.
This precludes the use of the Double Index instruments procedure presented in
Carrasco et al. (2007). (3) Since correlations are also stochastic, there are more
latent variables than in the stochastic volatility models, making simulation-based
methods useless. (4) The dimensionality of the problem makes the characteristic
function dicult to invert. (5) Finally, we show that the DCC-based estima-
tion method proposed in Buraschi et al. (2006) is unreliable in the WASC model
whenever we are interested in estimating the correlation structure of the model.
In view of these diculties, we propose to estimate the WASC model using its
characteristic function, following an approach that is closed to the ones presented
in Chacko and Viceira (2003) and Carrasco et al. (2007). We present a Monte
Carlo investigation of the estimates behavior in a small sample and we discuss
the empirical results obtained using a real dataset composed of the prices of the
SP500, FTSE, DAX and CAC 40. Our estimates reject systematically the partic-
ular correlation structure chosen by Gourieroux and Sufana (2004) and Buraschi
et al. (2006). Finally, the results show that the WASC model, thanks to its ability
to describe dynamic correlation, can encompass most of the desired features of
nancial markets.
The paper is organized as follows. First we present the WASC process, along
with the computation of its conditional characteristic function. Then in Section
3, we review the main estimation strategies and discuss the diculties linked to
discrete time models. In Section 4, we present the estimation methodology used
in this paper and briey review the main theoretical results. Finally, in Section 5,
we present the estimation results obtained with both simulated and real datasets
and discuss their interpretation.
3
2 The model
In this section, we present the Wishart Ane Stochastic Correlation model in-
troduced in Da Fonseca et al. (2006): we detail the diusion that drives this
multidimensional process and present the conditional characteristic function to-
gether with its derivatives.
2.1 The dynamics
The Wishart Ane Stochastic Correlation (WASC) model is a new continuous
time process that can be considered as a multivariate extension of the Heston
(1993) model, with a more accurate correlation structure. The framework of this
model was introduced in Gourieroux and Sufana (2004). It relies on the following
assumption.
Assumption 2.1. The evolution of asset returns is conditionally Gaussian while
the stochastic variance-covariance matrix follows a Wishart process.
In formulas, we consider a n-dimensional risky asset S
t
whose risk-neutral dy-
namics are given by
dS
t
= diag[S
t
]
_
dt +
_

t
dZ
t
_
, (1)
where is the vector of returns and Z
t
R
n
is a vector Brownian motion. Fol-
lowing Gourieroux and Sufana (2004), we assume that the quadratic variation of
the risky assets is a matrix
t
which is assumed to satisfy the following dynamics:
d
t
=
_

+M
t
+
t
M

_
dt +
_

t
dW
t
Q+Q

(dW
t
)

t
, (2)
with , M, Q M
n
, invertible, and W
t
M
n
a matrix Brownian motion (

denotes transposition). In the present framework we assume that the above dy-
namics are inferred from observed asset price time series, hence the stochastic
dierential equation is written under the historical measure.
Equation (2) characterizes the Wishart process introduced by Bru (1991), and
represents the matrix analogue of the square root mean-reverting process. In
order to ensure the strict positivity and the typical mean-reverting feature of the
volatility, the matrix M is assumed to be negative semi-denite, while satises

= Q

Q, > n 1, (3)
with the real parameter > n 1 (see Bru, 1991 p. 747).
In full analogy with the square-root process, the term

is related to the
expected long-term variance-covariance matrix

through the solution to the


following linear equation:

= M

. (4)
4
Moreover, Q is the volatility of the volatility matrix, and its parameters will be
crucial in order to explain some stylized observed eects in equity markets.
Last but not least, Da Fonseca et al. (2006) proposed a very special yet tractable
correlation structure that is able to accommodate the leverage eects found in
nancial time series and option prices. Since it is well known that it is possible
to approximately reproduce observed negative skewness within the Heston (1993)
model by allowing for negative correlation between the noise driving returns and
the noise driving variance, they proposed the following assumption:
Assumption 2.2. The Brownian motions of the asset returns and those driving
the covariance matrix are linearly correlated.
Da Fonseca et al. (2006) proved that Assumption 2.2. leads to the following
relation:
dZ
t
= dW
t
+
_
1

dB
t
, (5)
with Z
t
= (dZ
1
, dZ
2
, . . . , dZ
n
)

, B a vector of independent Brownian motions


orthogonal to W, as dened in equation (2), and = (
1
,
2
, . . . ,
n
)

.
With this specication, the model is able to generate negative skewness, given
the possibly negative correlation between the noise driving the log returns of the
assets and the matrix-sized noise perturbating the covariance matrix. This is
easy to show in the special case of two assets (n = 2), fow which the variance-
covariance matrix is given by

t
=
_

11
t

12
t

12
t

22
t
_
. (6)
The correlations between assets returns and their volatilities admit a closed form
expression, highlighting the impact of the parameters on its value and positivity:
corr
_
d log S
1
, d
11
_
=

1
Q
11
+
2
Q
21
_
Q
2
11
+Q
2
21
(7)
corr
_
d log S
2
, d
22
_
=

1
Q
12
+
2
Q
22
_
Q
2
12
+Q
2
22
, (8)
where we recall that

11
(resp.

22
) represents the volatility of the rst
(resp. second) asset. Therefore, the sign and magnitude of the skew eects are
determined by both the matrix Q and the vector . When Q is diagonal, we
obtain the following skews for asset 1 and 2:
corr
_
d log S
1
, d
11
_
=
1
corr
_
d log S
2
, d
22
_
=
2
, (9)
thus allowing a negative skewness for each asset whenever
i
< 0, i (see Gourier-
oux and Jasiak (2001) on this point). This correlation structure is similar the
5
one obtained in an Heston model.
Other less general specications close to the WASC model, actually nested within
the WASC correlation structure, have been proposed in the literature. First,
Gourieroux and Sufana (2004) imposed = 0
n
R
n
, a choice that leads to a
zero correlation case (see equations (5), (7) and (8)) by analogy with the well
known properties of the Heston model. With this specication, the log returns
univariate distribution is symmetric.
Second, Buraschi et al. (2006) proposed to impose = (1, 0)

. Their model is
thus able to display negative skewness for asset 1 (resp. asset 2), depending on
the positivity of Q
11
(resp. Q
12
). This model is actually close to the WASC and is
able to display similar features. Their choice of is less restrictive than it seems,
in so far as this parameter is only dened up to a rotation. Thus, their hypothesis
is reduced to [[[[ = 1. With these settings, the vector-sized noise in the returns is
fully generated by the Brownian motions of the covariances W. This hypothesis
having no a priori justication, the WASC model of Da Fonseca et al. (2006)
eliminates it, assuming the more general correlation structure compatible with
an exponential ane characteristic function (see Proposition 1 in Da Fonseca
et al. (2006) on this point).
2.2 The Characteristic functions
In the WASC model, the characteristic function of
t
and Y
t
= log S
t
is an expo-
nential ane function of the state variables. For the log returns, the characteristic
function of Y
t+
conditional on Y
t
and
t
is denoted:

Y
t
,
t
(, ) = E
_
e
i,Y
t+

[
t
, Y
t

, (10)
where E[.[
t
, Y
t
] denotes the conditional expected value with respect to the his-
torical measure, R
n
, i
2
= 1 and ., .) is the scalar product in R
n
.
Proposition 2.1. (Da Fonseca et al., 2006) The characteristic function of the
asset returns in the WASC model is given by

Y
t
,
t
(, ) = E
_
e
i,Y
t+

[
t
, Y
t

(11)
= exp Tr [A()
t
] +i, Y
t
) +c() , (12)
where = (
1
, . . . ,
n
)

R
n
and the deterministic function A(t) M
n
is as
follows:
A() = A
22
()
1
A
21
() , (13)
with
_
A
11
() A
12
()
A
21
() A
22
()
_
= exp
_
M +Q

2Q

Q
1
2
_
(i)(i)

n
j=1
i
j
e
jj
_

_
M

+i

Q
_
_
.
(14)
6
The function c() can be obtained by direct integration, thus giving:
c() =

2
Tr
_
log (A
22
()) +M

+i(

Q)

+Tr
_
i

. (15)
The characteristic function of the Wishart process is dened as:

t
(, ) = E
_
e
iTr[
t+
]
[
t

, (16)
where M
n
.
Proposition 2.2. (Da Fonseca, 2006) Given a real symmetric matrix D, the
conditional characteristic function of the Wishart process
t
is given by:

t
(, ) = E
_
e
iTr[
t+
]
[
t
, Y
t

= exp Tr [B()
t
] +C() , (17)
where the deterministic complex-valued functions B() M
n
(C
n
), C() C are
given by
B() = (iB
12
() +B
22
())
1
(iB
11
() +B
21
()) (18)
C() =

2
Tr
_
log(iB
12
() +B
22
()) +M

,
with
_
B
11
() B
12
()
B
21
() B
22
()
_
= exp
_
M 2Q

Q
0 M

_
.
What is more, both these characteristic functions can be derived with respect
to and the elements of M, Q and , using the results of Daleckii (1974), on
the derivative of a matrix function. We provide detailed calculations of these
derivatives in the Appendix.
3 Possible estimation strategies
In this section, we review the possible estimation strategies for the WASC. We
discuss how similar processes have been estimated in special correlation cases,
using the Dynamic Conditional Correlation model introduced by Engle (2002)
to make the time-varying covariances observable. This methodology has been
applied by Buraschi et al. (2006) to a particular specication of the WASC model
corresponding to the choice = (1, 0)

for the correlation structure. We show


why this approach cannot be pursued in the WASC correlation specication,
both from a theoretical and empirical point of view. Finally, we present a dis-
crete time model whose continuous time limit is the WASC model and explain
why such an approach may lead to the kind of estimation errors we want to avoid.
7
3.1 Preliminary considerations
The WASC model ts in the multivariate volatility models class and thus shares
the basic features of the univariate models. Univariate stochastic volatility models
are built upon an unobservable volatility process, making their estimation dicult
because of the available information in the conditioning. Dierent estimation
strategies have been proposed in the case of continuous time processes (see the
survey in Ghysels et al., 1996 and Ruiz and Broto, 2004). Only a few of them
could be applied to multivariate stochastic volatility models:
(1) The use of ltering has been proposed to circumvent the unobservable fea-
ture of stochastic variance, as in Harvey et al. (1994), where the gaussianity
of the factors made possible to apply the methodology of the linear Kalman
lter.
(2) The unobserved volatility process can be made observable using an exoge-
nous measure. The realized volatility have been extensively used for nan-
cial applications in the literature, see e.g. Barndor-Nielsen and Shephard
(2002).
(3) When using moment estimators based on the characteristic function, as
in the Heston model, the volatility can be integrated out, allowing for a
direct focus on the distribution of returns. Following Gourieroux (2006),
a spectral moment-based estimator can be constructed. Constructions of
this kind can be found in Chacko and Viceira (2003) and Rockinger and
Semenova (2005).
(4) Finally, in the special case of continuous-time stochastic volatility models,
a GARCH-like discrete time model that converges towards the continuous
time model can be constructed in the spirit of Nelson (1990).
Were it not for problems of dimension, similar methods could be applied to mul-
tivariate stochastic volatility models. Nevertheless, we review each of them and
discuss their applicability to the WASC model. Although it has been proposed
as an estimation method by Gourieroux (2006), we quickly discard the ltering
approach, since in our non Gaussian framework the non-linearity of the optimal
lter leads to a complicated numerical implementation.
3.2 Estimation when the covariances are observable
The rst possibility is thus to make the covariances matrix observable, using
a parametric or non-parametric measure. Non-parametric estimators have been
proposed in Barndor-Nielsen and Shephard (2004). Estimators of this kind have
been applied to a pure Wishart process (named Wishart Autoregressive Process or
WAR) in Gourieroux et al. (2004) using stock market data, in a moment-method-
based approach. A parametric approach has been proposed, using the Dynamic
Conditional Correlation model (Engle, 2002 and and Engle and Sheppard, 2001)
to estimate the daily covariances matrix. This methodology has been applied in
8
Buraschi et al. (2006) to a special case of the WASC, with the aforementioned
correlation structure = (1, 0)

and with a dataset made of stocks and interest


rates.
Methodologies of this kind, especially the parametric one, are particularly dicult
to apply to the WASC model for the following reasons. On one hand, the observed
covariances should now lead to a standard maximum likelihood estimation of the
WASC. However, the density is not available in a closed-form expression and the
numerical multivariate Fourier transform of the characteristic function is quite
computer intensive. On the other hand, any moment-based method will lead to
a lack of eciency, and in particular the DCC method cannot be used for the
WASC model in order to estimate the vector parameter, as we are going to show.
Let us shortly review the DCC model and provide numerical results. The DCC
model assumes that the returns of n assets possess a conditionally Normal distri-
bution with a zero mean and a covariance matrix H
t
. Thus:
r
t
[T
t1
^(0, H
t
) (19)
and
H
t
= D
t
R
t
D
t
, (20)
where D
t
= diag(
_
h
i
t
) is the diagonal matrix of time-varying standard deviations
and R
t
is the time-varying correlation matrix. The h
i
t
; i = 1, . . . , n follow a
univariate GARCH dynamic, with the usual parameter restrictions. The dynamic
of the correlation R
t
is given by:
Q
t
= (1 )

Q+
t1

t1
+Q
t1
R
t
= Q

t
1
Q
t
Q

t
1
,
with Q

t
= diag(

q
ii
) and
t
^(0, R
t
). Once again suitable constraints should
be imposed on and in order to guarantee a well-behaved R
t
matrix.
As long as the DCC model provides consistent estimates of the time-varying
variance-covariance matrices, it is possible to estimate M, Q and consistently,
by using the unconstrained rst-order method of moments estimator presented
in Gourieroux et al. (2004). In our case, such an approach is precluded by the
presence of : in fact, the DCC does not allow for correlation between the returns
vector and the covariance matrix, while this correlation is non-zero in the WASC
model and is parametrized by . To see why, recall that in the DCC model the
variances are assumed to follow a GARCH(1,1) specication. Thus, the dynamic
of the i
th
component is:
r
i
t
=
_
h
i
t

i
t
, (21)

i
t
N(0, 1) (22)
h
i
t
=
0
+
1
h
i
t1
+
2
(r
i
t1
)
2
. (23)
9
When computing the skew, we obtain:
Cov
t1
(r
i
t
, h
i
t+1
h
i
t
) =
2
h
3
2
t
E
t1
[(
i
t
)
3
] = 0. (24)
Thus, the variances obtained with a DCC model have no correlation with the
returns. A similar computation can be perform to show that the conditional co-
variance between the log of the asset price and the correlation process in the DCC
framework is equal to 0. These two key features preclude any DCC-based estima-
tion of in the WASC. This problem is well-known in nancial econometrics, at
least since Nelson and Foster (1994). We report in Figure 1 the empirical distri-
bution of the skew and estimators with DCC-based time-varying covariances,
when the true (simulated) data-generating process is the WASC, illustrating this
correlation-estimation problem. Thus DCC-based estimates cannot be used. One
interesting exception is the model presented in Cappiello et al. (2006). However,
in this case, as in the DCC case, we fear model-linked measurement errors: in
particular, we cannot quantify how well these models yield a consistent estima-
tion of the skew.
Finally, it is noteworthy to mention that the DCC cannot be used as a discretiza-
tion of the continuous time WASC model for estimation purposes. As presented
in Nelson and Foster (1994) in the univariate case, the use of a GARCH process
to estimate a square root diusion process lead to an estimator that is expected
to have a very low eciency. The WASC process being a matrix square root
process, we would face similar if not worst diculties by undertaking such a
strategy in our multidimensional settings. Coming back to DCC, this model is
usually estimated in a two-stage framework as volatilities and correlations can be
estimated separately. Clearly, the use of such an estimation strategy is dubious
for the WASC model since volatilities and correlations dwell on the same set of
parameters. We develop this point in the empirical results section as we detail
the dynamics of volatility and correlation in the two-dimension case. On the basis
of these arguments, the use of the DCC to estimate the WASC should clearly be
discarded as a possible estimation strategy. For these reasons, we present in the
next subsection a converging discretization of the WASC process.
3.3 Approximation of the WASC model by Stochastic Dif-
ference Equations
Another way to estimate continuous time processes consists in building a discrete
time model that converges towards the continuous time model, when the time lag
goes to zero. A methodology of this kind has already been applied to stochastic
volatility models by Nelson (1990). In this section, we build up a discrete-time
model of this kind that converges in probability towards the WASC model.
Following the seminal paper of Nelson (1990), we build up a stochastic dierence
equations approximation of the WASC. Our approach relies on the fact that
a Wishart process with integer Gindikin value can be written as a square of a
10
Ornstein-Uhlenbeck matrix process. On this point, see Bru (1991). This property
has been used by Gourieroux et al. (2004) to construct an estimator of a pure
Wishart process. Thus, there exists a matrix-sized stochastic process X
t
in M
n
such that
t
= X

t
X
t
and whose dynamics are given by
dX
t
= Mdt +dN
t

Q, (25)
with N
t
; t 0 a n matrix Brownian motion and

Q the rotation of Q,
so that

Q is symmetric. What is more, the link between N and W is known
from Bru (1991). Thus, once the link between Z and N has been found (see
the Appendix), we are able to specify the WASC with the following stochastic
dierential equation:
_
dY
t
=
_
+
1
2
Vec((X

X)
ii
)
_
dt +

XdZ
t
dX
t
= Mdt +
_
diag(dZ
t
)
t
+ diag(d

Z
t
)

t
+ diag(d

Z
t
)

t
+ diag(d

Z
t
)

t
_

Q,
(26)
with Z,

Z,

Z and

Z independent Brownian motions. ,

,

and

are func-
tions of the (rotated) parameter and of X
t
. Using this result and the ones
in Nelson (1990), we can provide a discrete time model converging towards the
WASC. From the Hermite polynomials theory we can build from
k
; k N
some sequences of uncorrelated normalized Gaussian variables, due to the fact
that E[H
i
(U)H
j
(U)] =
ij
c
i
with ^(0, 1), where
ij
is the Kronecker function
and c
i
= i!. By taking the limit, these sequences will converge to independent
Brownian motions, thus extending to a dimension greater than two the theorem
3.2 of Nelson (1990). We illustrate such converging sequences in the following
lemma, whose proof is provided in the Appendix.
Lemma 3.1. Let t
k
; k N be such that t
i
t
i1
= . Denote by (Y

t
k
, X

t
k+1
)
the solution of the stochastic dierence equations
_
Y

t
k
Y

t
k1
=
_
+
1
2
Vec((X

t
k
)

t
k
)
ii
_
+
_
X

t
k
_

t
k

t
k
X

t
k+1
= X

t
k
+M +

N
t
k

,
where
t
k
; k N are i.i.d ^(0, I
n
),

N
t
k
is given by

N
t
k
=
_
H
1
(
1
t
k
) 0
0 H
1
(
2
t
k
)
_

t
k

c
1
+
_
H
2
(
1
t
k
) 0
0 H
2
(
2
t
k
)
_

t
k

c
2
+
_
H
3
(
1
t
k
) 0
0 H
3
(
2
t
k
)
_

t
k

c
3
+
_
H
4
(
1
t
k
) 0
0 H
4
(
2
t
k
)
_

t
k

c
4
,
with c
i
= E[H
i
(U)
2
], U ^(0, 1) and H
i
(x) is the i
th
Hermite polynomial.
The process (Y

t
k
, X

t
k+1
) converges weakly to (Y
t
, X
t
) as t 0, with (Y
t
, X
t
)
dened previously.
Even though this approach is attractive, insofar as it makes the conditioning
easier, we will not pursue this direction. As already pointed out by Nelson (1990),
11
it remains to prove that the discrete approximation scheme will provide consistent
estimates of the continuous time model parameters. The question of consistency
and eciency, when dealing with unobservable components in the dynamics, is
of tremendous importance. We presented the previous discretization in order to
cast some light on the possibility of estimating a discrete version of the WASC,
without using the GARCH-like model, because of the need to estimate the
vector-sized parameter. Nevertheless, we have little control on the impact of the
discretization error brought about by such a procedure. Thus, instead of following
the approximation procedure, we prefer to turn our attention toward the use of
the exponential ane characteristic function of the WASC process, for which
we have well-established results related to Generalized Method of Moment-based
estimation procedures.
4 Spectral GMM in the WASC setting
Recent papers presented estimation methodologies using the empirical character-
istic function as an estimation tool, since this function has a tractable expression
for many continuous time processes. In this section, we present how to estimate
the WASC in this framework, building on the approaches developed in Chacko
and Viceira (2003) and Carrasco et al. (2007).
The usual way to present the generalized method of moments based on spectral
moment conditions unfold as follows. Let h
t
be the conditional moment condition
such that
h
t
= e
iw,Y
t+
Y
t

X, (27)
with the notations developed earlier. X is a non stochastic function of the process
parameters. Let g(Y
t
) be the instruments. We need to identify X such that the
following relation holds:
E[h
t
g(Y
t
)] = 0 E[e
iw,Y
t+
Y
t

g(Y
t
)] E[Xg(Y
t
)] = 0. (28)
As what can be found in Chacko and Viceira (2003), the usual way to proceed
consists in setting
X = E[e
iw,Y
t+
Y
t

[Y
t
]. (29)
In the WASC case, X is thus set to be equal to :
X = e
c()
E[e
A(),
t

[Y
t
] = e
c()

0
(t, iA()), (30)
with c() dened in equation (15), A() dened in equation (13) and

t
(.) de-
ned in equation (17). Clearly, in such a case equation (28) has no reason to
be equal to zero. The relation only holds if (Y
t
)
tN
and (
t
)
tN
are independent
processes or if g(Y
t
) = 1. The autonomous behavior of the matrix volatility is
not equivalent to having an independent process. Since in the WASC case this
12
independence is false, we imposed the instrument value to be 1, as in Chacko and
Viceira (2003) (see page 272). A spectral GMM approach cannot be undertaken
otherwise
1
. This setting stems from the fact that we integrate the volatility out
when computing X. Could we use
t
as an instrument, a more general form of
instruments would be readily used.
In order to increase the eciency of our estimates, we use a continuum of moment
conditions, as presented Carrasco et al. (2007). Note that the fact that we set the
instruments to be equal to 1 naturally prevents us from reaching the ML eciency
of CGMM estimates of Carrasco et al. (2007). Anyway, Y
t
conditionally upon its
past is no longer a Markov process, since the covariance matrix is unobservable.
ML eciency cannot be reach for non-Markov process: the special instruments
chosen here does not necessarily jeopardize the estimation results.
Let now

h
t
(.) be the sample mean of the moment condition, that is a function
from R
2n
to C. In an innite conditions framework, Carrasco et al. (2007) showed
that the objective function to minimize is:

= arg min

|K
1/2

h()|, (31)
where K is the covariance operator, that is the counterpart of the covariance
matrix in nite dimension as in standard GMM approach and |.| is the weighted
norm
|f|
2
=
_
R
n
_
R
n
f()f()()d
where denotes any probability measure. As in Carrasco et al. (2007), we chose it
to be the normal distribution. Carrasco et al. (2007) showed that the covariance
operator K can be written as follows:
Kf() =
_ _
k(, )f()()d
where the function k is the so called kernel of the integral operator K and is
dened by:
k(, ) =
+

j=
E

0
_
h
t
(;
0
)h
tj
(;
0
)
_
.
Since our approach is nested within the Carrasco et al. (2007)s, we now thor-
oughly follow their settings. Our approach can also be related to the methodology
presented in Rockinger and Semenova (2005). In order to construct an estimator
of the covariance operator, Carrasco et al. (2007) proposed a two-step procedure.
The rst step consists in nding:

1
= arg min

h()|. (32)
1
We thank Marine Carrasco for pointing out this fact.
13
Since h
t
is not a martingale dierence series, the second step consists in estimating
the kernel k as follows:

k(
s
,
r
,
v
,
w
) =
T
T q
T1

j=T+1

_
j
S
T
_

T
(j), (33)
with

T
(j) =
_
1
T

T
t=j+1
h
t
(
s
,
r
,

1
)h
tj
(
v
,
w
,

1
), j 0
1
T

T
t=j+1
h
t+j
(
s
,
r
,

1
)h
t
(
v
,
w
,

1
), j < 0,
, (34)
where w(.) is any kernel satisfying some regularity conditions (see Carrasco et al.
(2007) Appendix A.6) and S
T
is a bandwidth parameter.
Once the covariance operator is estimated, the minimization in equation (31)
requires the computation of the inverse of K. Unfortunately, K has typically
a countable innity of eigenvalues decreasing to zero, so that its inverse is not
bounded. We need then to regularize the inverse of K, which can be done by
replacing K by a nearby operator that has a bounded inverse, due to the presence
of a penalizing term. Carrasco et al. (2007) used the Tikhonov approximation of
the generalized inverse of K. Let be a strictly positive parameter, then K
1
is
replaced by:
(K

)
1
= (K
2
+I)
1
K. (35)
As outlined in Carrasco et al. (2007), the choice of is important but does not
jeopardize the consistency of the estimates. Carrasco and Florens (2000) investi-
gated an empirical method to select its value, and the optimal value for it should
represent a trade-o between the instability of the generalized inverse (for small
values of ) and the distance from the true inverse as increases. Furthermore
we found much more convenient to compute (K

)
1
using the Choleskys de-
composition than the spectral decomposition: it is sucient for the evaluation of
equation (31) and avoids the numerically dicult problem of eigenvectors com-
putation.
Under mild regularity conditions (conditions A.1. to A.5. in Carrasco et al.,
2007), it can be proved that the optimal C-GMM estimator of is obtained by:

= arg min

|(K

T
)
1/2

h
T
()| (36)
and is asymptotically Normal with

T(

T

0
)
L
^
_
0, (E

0
(

h), E

0
(

h))
K
)
1
_
, (37)
as T and T
a

5/4
T
go to innity and goes to zero. (

h denotes the Jacobian


matrix of h(.)).
Finally, it is important to mention that Carrasco et al. (2007) present a matrix-
based version of their estimation method that may be more appealing than the
one presented here for a WASC model based on more than two assets or for other
models.
14
5 Empirical Results
We now review the empirical results obtained with the aforementioned estimation
methodology. First, we provide insight into the model and the parameters inter-
pretation. Then we review the results of a Monte Carlo experiment investigating
the empirical behavior of the estimation methodology. Finally, we present the
estimates obtained using equity indexes and discuss the results obtained.
5.1 Preliminary considerations
Unlike the Heston (1993) model, the Wishart Ane Stochastic Correlation model
is a new model for which the parameters interpretation is not immediate. Such
an interpretation is however essential to the understanding of the model and for
its estimation. For the sake of simplicity, we focus on the case where n = 2, i.e.
the case for which we observe two assets. Y
t
is the vector containing the log of
the asset prices, and
t
is its covariance matrix given by equation (6). Y
1
t
being
the log return of the rst asset, its volatility is given by
_

11
t
. In the WASC
framework, individual parameters can hardly be interpreted on their own: on the
contrary, combinations of these parameters have standard nancial interpreta-
tions, such as the mean-reverting parameter or the volatility of volatility. Now,
we review the computation of these quantities.
For the rst asset, the quadratic variation of the volatility can be computed as
follow:
d
11
,
11
)
t
= 4
11
t
(Q
2
11
+Q
2
21
)dt, (38)
for the rst asset. Therefore the rst column of Q parametrizes the volatility of
volatility of the rst asset. Similar results can be obtained for the second asset.
Then, as presented in Section 2,
corr
_
dY
1
, d
11
_
=
Q
11

1
+Q
21

2
_
Q
2
11
+Q
2
21
, (39)
where corr(.) is the correlation coecient. As already mentioned, the short term
behavior of the smile and the skewness eect heavily depend on the correlation
structure given by the vector . If Q and are such that this quantity is negative,
then the volatility of S
1
will rise in response to negative shocks in returns of this
asset. We expect this correlation to be large and negative, in order to account
for the large skewness found in nancial datasets.
The Gindikin coecient insures the positiveness of the Wishart process. What
is more, an increase of it will shift the distribution of the smallest eigenvalue
to positive values. Thus, this parameter can be interpreted as a global variance
shift factor. From equations (3) and (4), if is multiplied by a factor , the
long term covariance matrix

will be multiplied by the same factor. also


15
impacts the mean reverting and variance of the correlation process. The higher
the parameter and the lower the persistence and the variance of the correlation
process. Thus, there is a trade-o in the WASC model between volatility of the
returns and volatility of the correlation process.
The M matrix can be compared to the mean reverting parameter in the Cox-
Ingersoll-Ross model. Like for the parameters previously investigated, the ele-
ments of this matrix can hardly be interpreted directly. However, we can compute
in a closed form expression the drift part of the dynamics of
ij
. In the case of
the rst asset:
d
11
t
= . . . +
11
t
_
2M
11
+ 2M
12
_

22
t
_

11
t

12
t
_
+. . . , (40)
where
12
t
is the instantaneous correlation between the log-returns of the two
assets. Thus, the mean reverting parameter for
11
is a combination of the ele-
ments of M. What is more, this drift term is made of two parts: a deterministic
part (2M
11
) and a stochastic correction (2M
12

22
t

11
t

12
t
), linked to the joint dy-
namics of both assets. Thus, the drift term of
11
t
is inuenced by one of the
o-diagonal elements of M. This feature cannot be replicated by most of the mul-
tivariate GARCH-like models. We can perform similar calculations for
12
t
and

22
t
. These quantities can then be used to compare the half life of the variances
and covariance processes and thus evaluate their relative persistence in nancial
markets.
The instantaneous correlation between assets has also a closed form expression:
d
12
t
=
_
A
t
_

12
t
_
2
+B
t

12
t
+C
t
_
dt +
_
1 (
12
t
)
2
(...)d(Noise
t
) (41)
with A
t
, B
t
, C
t
recursive functions of
11
t
,
22
t
and the model parameters. We
present the drift coecients and the diusion term in the Appendix. The drift
associated to the correlation is quadratic, and the linear term has a negative co-
ecient B
t
< 0, thus presenting the typical mean reverting behavior of
12
t
(at
least around zero where the quadratic part is negligible). The linear part can
thus be used to analyze the persistence of the correlation and its mean-reverting
characteristics, during low correlation periods. When the absolute value of the
correlation is higher, the quadratic part of the drift get the upper hand and the
correlation process looses most of its persistence. By comparing the values of
B
t
and A
t
, when can thus compare the correlation behavior during low and high
correlation cycles. This information has not been documented until now, whereas
it is important to understand the joint behavior of nancial assets.
The WASC model can also be used to investigate potential contagion eects in
nancial markets. By computing the correlation between the correlation process
and the returns, we can discuss under which condition the model is able to display
16
an asymmetric correlation eect
2
. Asymmetric correlation eect leads correlation
to go up whilst returns are getting down. As already noticed in Da Fonseca et al.
(2006), we have:
dY
1
,
12
)
t
=

11
t

22
t
(1
_

12
t
_
2
) (Q
12

1
+Q
22

2
)
. .
Sign of asset 2 skew
. (42)
Thus, the sign of the skews determines the one of the covariance between correla-
tion and returns. Were the skew to be negative and the model would also display
increases in the correlation following negative returns. Thus, the WASC model is
also able to display an asymmetric correlation eect, whose sign is driven by the
skewness associated to the returns. Since the asset returns are negatively cor-
related to their own volatility (leverage eect), we thus expect volatilities to be
positively correlated to correlation: negative returns periods correspond to both
higher correlation and higher volatility periods. In fact, simple computations
given in Appendix lead to
d

12
,
11
_
t
=

11
t

22
t
_
1
_

12
t
_
2
_

Q
12
_

Q
11
+

Q
22
_
dt.
where

Q is the symmetric positive denite matrix associated to the polar decom-
position of Q
3
. A positive value for

Q
12
would mean that the WASC model is able
to accomodate stylized eects of the type mentioned earlier. Due to the increase
in the drift term of the correlation dynamics, situation of this kind are expected
not to last for long.
We now turn our attention toward a series of Monte Carlo experiments, so as to
investigate the empirical performance of the chosen estimation strategy.
5.2 Monte Carlo study
Following Carrasco et al. (2007), we present the results of a Monte Carlo study
of the CGMM estimation methodology applied to the WASC. We rst present
the technical details of the simulation and then we review the results obtained.
For the ease of the presentation, we restrict to the two-assets case. The parame-
2
On asymmetric correlation eects, see Roll (1988) and Ang and Chen (2002).
3
Any invertible matrix Q can be uniquely written as the product of a rotation matrix and
a symmetric positive denite matrix

Q, see the Appendix.
17
ters used in the simulation are the following:

0
=
_
0.0225 0.0054
0.0054 0.0144
_
(43)
M =
_
5 3
3 5
_
(44)
=
_
0.3 0.4

(45)
Q =
_
0.1133137 0.03335871
0.0000000 0.07954368
_
(46)
= 15. (47)
The Q matrix is obtained by inverting the relation that links Q to M,

and :
Q

Q =
1

_
M

_
. (48)
This ensure the stationarity of the correlation process. When Q is selected arbi-
trary and given the mean reverting property of
t
, the rst part of the simulated
sample will be tainted by the collapse of the process toward its long term average.
Situations of this kind should be discarded. The Figure 2 presents a simulated
path for both volatilities and correlation, using the previous parameter values.
The gure displays mean-reverting dynamics for each of these moments.
The Figure 3 shows the characteristic function used in the spectral GMM method
used in the paper, as presented in equation (29). The grid used for the numerical
integration of the objective function ranges on the real line from -300 to 300.
We used Gaussian kernels with appropriate variance parameter to maintain as
much information as possible. The integral is computed numerically using the
Trapezoidal Rule that seemed to performed well over the simulated dataset. The
objective function is minimized using a simulated annealing method, as described
in Belisle (1992).
We present the results of dierent Monte Carlo experiments. Each of them comes
out after 1000 iterations, but they dier by the length of the simulated sample
and the sampling frequency: daily, weekly and monthly. For each sampling fre-
quency, we used two dierent samples, one of which contains 500 observations
and the other one 1500 observations. The Table 7.3 presents the Mean Bias and
the Root Mean Square Error (RMSE) obtained. We did not reported the median
bias insofar it was close to the median bias, thus indicating that the estimators
have a symmetric empirical distribution.
The results can be analyzed as follows. The Monte Carlo results obtained for Q,
and show that an increase in the sample depth globally results in a reduction
of the variance of the estimates. The bias obtained are small and not signica-
tive. For the weekly frequency,
1
displays a noticeable dierence as the variance
of the estimate grows with the sample size. This feature will have to be consid-
ered when analyzing the real dataset-based estimation results. The M parameter
18
also presents this variance increase feature. However, this behavior is not very
surprising: a large number of articles emphasize the diculties involved by the
estimation of the mean reverting parameter in continuous time diusions (see e.g.
Gourieroux and Monfort, 2007). The Monte Carlo results indicate that this mean
reverting parameter is estimated with less volatility with daily series. What is
more, diagonal elements (resp. o-diagonal elements) of M are estimated with a
small positive (resp. negative) bias and thus may be underestimated (resp. over-
estimated) when working with a real-time dataset. Finally, the correlation vector
displays a remarkably small bias and small RMSE for the daily datasets, even
in the small sample version. This fact is somewhat constant for each sampling
frequency. This point is important for the WASC model, given that we are in-
terested in the analysis of the ne correlation structure implicit in asset dynamics.
We now detail the empirical results obtained with stock indexes.
5.3 Estimation on stock indexes
In this last subsection, we present the empirical results obtained when estimating
the WASC using the C-GMM method on a real dataset. We used the following
stock indexes: SP500, FTSE, DAX and CAC 40. For each stock, the time series
starts on January 2nd 1990 and ends on June 30th 2007. This period excludes
the 1987 crash and the subprime crisis. It nonetheless includes a lot of nancial
turmoils, as pointed in Rockinger and Semenova (2005). The table 2 presents
the descriptive statistics for the sample used in the estimation, at a weekly sam-
pling frequency. We used daily and weekly time series. We discarded the use of
monthly ones since the sample would be far too small. In many articles devoted to
the estimation of continuous time models, the change in the sampling frequency
usually leads to an interesting analysis of the subtle dynamics of nancial mar-
kets (see e.g. Chacko and Viceira, 2003). Since the characteristic-function based
estimators do not suer from discretization errors, we can actually use any sam-
pling frequency. Like in Carrasco et al. (2007), = 0.02 were found to perform
well. The integration grid is the same as the one used for the previous simulation
exercises. We chose to use the Bartlett kernel for the GMM covariance matrix
estimation, following the procedure presented in Newey and West (1994).
For numerical sake, we focus again on a two-assets case (n = 2). We estimated
the parameters driving the WASC process for the following couples of indexes:
(SP500,FTSE), (SP500,DAX), (SP500,CAC), (DAX/CAC), (DAX,FTSE) and
(FTSE/DAX). This way, we will be able to compare the characteristics specic
to individual stock while estimated with each of the others. For example, we will
be able to compare the volatility of volatility of the SP500, when it is estimated
with the DAX, CAC and FTSE as a second asset. It will highlight the impact of
joint dynamics on idiosyncratic behaviors, which has hardly be documented until
now.
The estimation results are presented in table 3 for the daily results and in table
19
4 for the weekly results. Most of the estimates are signicative up to a 5 or 10%
risk level. What is more, in the weekly observation case, the size of the sample is
strongly reduced and so is the eciency of the estimation method. Nevertheless,
the estimation results yield interesting information both about the WASC process
and the dynamics of the stock indexes.
As presented in the previous subsection, it is dicult to compare the individual
parameters and we will thus focus on combinations of these parameters most of
which are comparable with the ones of the Heston (1993) model.
For the estimated parameters presented in Table 3, the associated volatility of
volatility are presented in Table 5. The estimation of this quantity is essential
to test the ability of the model to capture nancial market features: as pointed
out in Chacko and Viceira (2003), this parameter controls the kurtosis of the
underlying process. Several remarks can be made. First, the global results match
what is generally expected from stock indexes. Such markets are known to lead to
a volatility of volatility ranging from 5% to 25%. Second, the results obtained for
the SP500 are remarkably stable when the second asset changes at least for the
daily sample: it ranges from 14.6% to 24.4%, thus matching the results obtained
in Eraker et al. (2003). Still, it is below the estimates obtained in Chacko and
Viceira (2003) and Rockinger and Semenova (2005): this may be explained by
the fact that the model that is estimated here is multivariate, whereas existing
attempts to capture stochastic volatility has been made in a univariate framework.
Da Fonseca et al. (2006) showed that the correlation between the volatility of each
stock is non 0 insofar as
d
11
,
22
) =
12
dt. (49)
Hence, whenever
12
is positive, the WASC model is able to model volatility
transmission phenomena among assets. It is noteworthy to remark that these
results are globally stable across the datasets and close to the existing results.
Third, when the sampling frequency reduces, the volatility of volatility parame-
ter globally increases. The few lacks of consistency for this fact may be due to
the fact that the number of observations in the weekly dataset is far below the
one used in the daily dataset. These results are dierent from those obtained in
Chacko and Viceira (2003). However, this is in line with what is observed for the
volatility of the log-returns when reducing the sampling frequency. This diver-
gence may also be explained by the eect of the correlation between variances
that cannot be mimicked in a Heston-like framework.
Now, let us discuss an important parameter for the specication of the WASC
model, that is the correlation between the returns and the volatility. We already
mentioned that this parameter is essential to have a model that is consistent with
many stylized facts, such as negative skewness and thus skewed implied volatility
surfaces. It can be computed using its expression given in equation (39). The
Table 6 displays the results obtained.
20
This time, we have results that are comparable to the one obtained in the existing
literature, and especially for the SP500. The correlation for this index is reported
in the rst line of the previous Table. In the literature, it actually ranges from
-0.27 (Rockinger and Semenova, 2005) to -0.62 (Chacko and Viceira, 2003), which
is close to what is obtained here. The parameter values obtained for the CAC,
DAX and FTSE indexes are not surprising either, since their sign is negative.
The main problem here lies in the instability of the parameter for the dierent
estimation involved, when comparing both the sample frequency and the couple
of indexes that are estimated. The change in sampling frequency does not lead
to a similar behavior across the datasets: depending upon the couples and the
sampling frequency, the skewness in the dataset can considerably dier, underlin-
ing the fact that correlation processes implicit in nancial markets are complex.
Beyond the remarks made in the previous paragraph on the importance of the
dataset depth, we also emphasize that the computation of this parameter dwells
on the inverse of the square root of a quantity that is small. In this situation,
the inverse of something small can be found to be very variable: any error in the
estimation of Q
11
and Q
21
will have a strong impact on
1

Q
2
11
+Q
2
21
. Thus, this
skewness quantity must be cautiously interpreted. Last but not least, since the
skews are negative, the tted WASC models also display asymmetric correlation
eects: negative returns are likely to be followed by a higher correlation between
the two assets.
We now turn our attention toward the mean reverting matrix M. For SP500,
CAC, DAX and FTSE, we nd the same structure for the matrix M. They are
denite negative thus ensuring a mean reverting behavior for the Wishart process
and have positives o diagonal terms. As presented in the previous subsection,
the drift can be decomposed into two dierent part: an idiosyncratic part (de-
noted
1
in the tables) and a joint part (denoted
2
in the tables). For univariate
stochastic volatility models, the estimation results usually lead to an estimate
of =
1
+
2
, that is the sum of the two preceding elements. Thanks to the
complexity of the WASC process, we are now able to disentangle and analyse
these two dierent elements. The estimation results are reported in table 8. The
values should be compared with the mean reverting value of the Heston. We
are close to Rockinger and Semenova (2005) results who found 6.3352 (see their
Table 1) for the S&P500, even though their results are obtained on a dierent
sample and using daily data. However, when analysing
1
and
2
, we nd that the
idiosyncratic mean reverting component is always higher than the usual Heston
parameter. This idiosyncratic element is dampened by the negative joint mean
reverting component: its negativity is to be related to the negative non-diagonal
elements of the estimated M matrices. Again, when the sampling frequency
changes, each of these values vary, suggesting that the mean reverting parame-
ter associated to the volatility strongly depends on the sampling frequency, as
pointed out in Chacko and Viceira (2003). Globally, the associated half lives are
around one month, which is a realistic value.
21
As presented in the previous section, it is possible to perform similar computa-
tions for the drift term of the stochastic correlation. This drift is a non linear
function of
12
t
and the usual comments have to be adapted. We present in gure
4 and 5 the instantaneous variation of
12
t
as a function of
12
t
, highlighting the
contribution of the quadratic term when the correlation gets very high that
is during crisis period. Our results suggest that the correlation process is much
more persistent than volatility when the correlation is below its long term level,
since in such a case its mean reverting parameter can be reduced to (B
t
): in
this situation, the half life is around 2 months, which is again realistic. When
correlation is high, the quadratic term gets higher and the persistence goes down,
since A
t
is added to B
t
as both these elements are negative. This is consistent
with what is empirically observed during nancial market crises: the correlation
gets very high on a very short period, to nally go back to its long term behavior
rapidly. The aforementioned gures display reaction functions of this kind, un-
derlining the ability of the WASC model to encompass this standard feature of
nancial markets.
Another quantity of importance is [[[[, since the WASC can be seen as a general-
ization of the processes proposed in Gourieroux and Sufana (2004) and Buraschi
et al. (2006), with a more complex correlation structure. Since the WASC model
is only dened up to a rotation matrix, the model presented in Buraschi et al.
(2006) encompasses any correlation structure that satises [[[[ = 1. Testing
such an assumption is thus of a tremendous importance to judge whether the
complexity of the WASC is empirically justied. The table 10 presents the norm
of this vector parameter. Each of the estimated value strongly diers from 1,
suggesting the general correlation structure imposed in Da Fonseca et al. (2006)
is empirically grounded.
As presented earlier, a contagion eect can be handled by the WASC through a
positive value for

Q
12
. In table 11 we report the estimated values for this param-
eter. We found positive values for all couples of indexes as expected. Therefore,
the estimated WASC model is able to detect the existence of potential contagion
eects in the dataset. As mentioned earlier, these ndings may be due to the fact
that the dataset includes several nancial crises, periods during which dramatic
contagion eects are expected.
6 Conclusion
In this paper we investigated the estimation of a new continuous time model:
the Wishart Ane Stochastic Correlation model, presented in Da Fonseca et al.
(2006). After having presented the problem that arise when trying to estimate
a discrete version of this model, this paper proposes to estimate the process us-
ing its exponential ane characteristic function. The estimation method uses a
continuum of spectral moment conditions in a GMM framework. After a pre-
22
liminary Monte Carlo investigation of the estimation methodology, we show that
real-dataset estimation results bring support to the WASC process. First, the
empirical results are comparable to those obtained in the literature (when com-
parable). Second, the general correlation structure of the WASC casts light on
not-so-well documented features of international equities, allowing us to discuss
for example the persistence of the correlation process, contagion eects or asym-
metric correlation eects. Third, the generality of the correlation structure is
not rejected by the dataset, bringing empirical support to the model presented
in Da Fonseca et al. (2006).
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25
7 Appendix
7.1 Computing the gradient
The gradient of the characteristic function is needed to study the asymptotic
distribution of the estimates but also in the optimization process underlying the
estimation procedure. Therefore we turn our attention to the dierentiation of
matrix function depending on a parameter. We illustrate the theoretical frame-
work with the characteristic function of the assets log returns and we give without
technical details the results for the forward characteristic function needed in our
empirical study. We mainly rely on the work of Daleckii (1974) for the general
case (i.e. in the non-Hermitian matrix case) and to Daleckii and Krein (1974),
Donoghue (1974) and Bathia (2005) for the Hermitian matrix case.
Let us rst state some basic results on linear algebra. Denote by
i
; i = 1..n
the set of eigenvalues of a matrix X M
n
and m
i
the multiplicity of
i
as a
root of the characteristic polynomial of X. Dene L
i
= Ker(X
i
I) and P
i
the
projection operator from C
n
onto L
i
, then we have

n
i=1
P
i
= I. Dene also J
i
such that (X
i
I)P
i
= J
i
. The Jordan normal form of X if given by the well
known decomposition X =

n
i=1
(
i
P
i
+J
i
).
Let f be a function from M
n
into M
n
: the derivative of f at X in direction H,
denoted D
f,X
(H), is by denition |f(X + tH) f(X) D
f,X
(H)| = to(|H|)
and can be computed using the following formula Daleckii (1974):
D
f,X
(H) =
n

j
1
,j
2
m
j
1
1

r
1
=0
m
j
2
1

r
2
=0
1
r
1
r
2

r
1
+r
2

r
1
j
1

r
2
j
2
_
f(
j
1
) f(
j
2
)

j
1

j
2
_
P
j
1
J
r
1
j
1
HP
j
2
J
r
2
j
2
. (50)
Remark 7.1. Whenever
j
1
=
j
2
the term within the bracket should be replaced
by f

(
j
1
).
Remark 7.2. When X can be diagonalized then m
j
= 1 for each j and we are
lead to the very simple form
D
f,X
(H) =
n

j
1
,j
2
_
f(
j
1
) f(
j
2
)

j
1

j
2
_
P
j
1
HP
j
2
. (51)
If X is Hermitian then P
1
= P

and we recover the result presented for example


in Daleckii and Krein (1974).
Simple algebra leads to D
f,X
(H) = PM
f
(P
1
HP)P
1
where P is the matrix of
the eigenvectors of X
4
, is the Schur product
5
and M
f
= (M
f
(
k
,
l
))
{k=1...n,l=1...n}
is the Pick matrix associated to the function f, which is dened by
M
f
(, ) =
_
f()f()

if ,=
f

() if =
(52)
4
If p
i
is the i
th
eigenvector of X and q
i
is the i
th
row of P
1
then the projection operator
on L
i
is given by P
i
= p
i
q

i
5
Given two matrix of same size X
kl
and Y
kl
then X Y = X
kl
Y
kl
26
This formulation is well known and can be found for example in Donoghue (1974)
p. 79 and Bathia (2005) p123-124.
The gradient of the characteristic function involves

A where A is given by (13).


In fact for any parameter value which may be equal to M
kl
, Q
kl
, R
kl
or the
gradient is given by

Y
t
,
t
(, z) = (Tr(

A
t
) +

c())
Y
t
,
t
(, z).
From (13) and

(L
1
) = L
1
(

L)L
1
implied by the derivation of L
1
L = I
we conclude that

A() = A
22
()
1

(A
22
())A() +A
22
()
1

A
21
() ,
Therefore we are lead to the computation of
_

A
11
()

A
12
()

A
21
()

A
22
()
_
,
that is the derivative with respect to a parameter of a function of a matrix (in
this case the exponential function). In order to use formula (50) we specify in the
following table for each parameter of the WASC model the choice of the matrice
X and H. As usual e
l
; l = 1 . . . n resp. e
kl
; k, l = 1 . . . n stands for the
canonical basis of R
n
resp. M
n
(R) (the function f being f(x) = e
x
).
Parameter X H
M
kl
G
_
e
kl
0
0 e
kl

_
Q
ij
G
_
(e
kl
)

2(Q

e
kl
+ (e
kl
)

Q)
0 i

e
kl
_

l
G
_
Q

e
l
i

0
0 ie

l
Q
_
To fulll the analytical computation of the gradient we need the derivative of c()
with respect to a model parameter and particularly the term log A
22
().

c() =

2
_
Tr (

(log A
22
())) +Tr
_

+i

Q)
_
(53)
In order to apply (50) we just need to dene P
22
from M
2n
into M
n
such that
P
22
L = L
22
with
L =
_
L
11
L
12
L
21
L
22
_
. (54)
Then it is easy to see that

log A
22
() = D
log,A
22
()
(P
22
D
exp,G
(H)) (55)
Once again using (50) with the log function gives the result.
27
Remark 7.3. If f is the exponential function then we can also compute the
derivative of the exponential of a matrix using the Baker-Hausdors formula
(see e.g. Hall (2003) p. 71 formula (3.10) for the details)

e
G
= Dexp
G

(G), (56)
where ad
X
Y = [X, Y ] = XY Y X is the Lie bracket and Dexp
X
= e
X Ie
ad
X
ad
X
.
The empirical study is based on the forward characteristic function of assets log
returns dened by

0
(t, iA())e
c()
= exp Tr [B(t)
0
] +C(t) +c() (57)
with
B(t) = (A()B
12
(t) +B
22
(t))
1
(A()B
11
(t) +B
21
(t))
C(t) =

2
Tr
_
log(A()B
12
(t) +B
22
(t)) +tM

c() =

2
Tr
_
log(A
22
()) +M

+i(

Q)

As for the characteristic function of assets log returns it is straightforward to


show that for any given model parameter we have:

0
(t, iA())e
c()
=

0
(t, iA())e
c()
(Tr(

B(t)
0
) +

C(t) +

c()))
where the matrix derivatives are given by

B(t) = (A()B
12
(t) +B
22
(t))(

A()B
12
(t) +A()

B
12
(t) +

B
22
(t))
1
B(t)
+ (A()B
12
(t) +B
22
(t))
1
(

A()B
11
(t) +B
21
(t)),

C(t) =

2
Tr(D
log,A()B
12
(t)+B
22
(t)
(

A()B
12
(t) +A()

B
12
(t) +

B
22
(t))).
This completes the analytical computation of the gradient.
7.2 WASC approximation
To prove the convergence of the discrete time process dened in Lemma 3.1 to
the WASC model we rst make some simplications.
Using the fact that Q GL(n, R)
6
we know that Q = K

Q with K O(n)
and

Q T
n
where O(n) stands for the orthogonal group
7
and T
n
is the set of
symmetric positive denite matrices. We refer to Faraut (2006) for basic results
on matrix analysis. The matrix Brownian motion being invariant under rotation
the dynamic can be rewritten as :
d
t
=
_

+M
t
+
t
M

_
dt +
_

t
d

W
t

Q+

Qd

W

t
_

t
. (58)
6
GL(n, R) is the linear group, the set of invertible matrices.
7
O(n) = g GL(n, R)[g

g = I
n

28
The associated correlation structure is = K

. Note that

Q

= Q

thus the
WASC models build upon (, M, Q, ) and (, M,

Q, ) have same characteristic
function. From now on we will work with the (, M,

Q, ) specication without
loss of generality.
To build a discrete time approximating scheme to the WASC it is tempting to
use an Euler scheme. Unfortunately a major diculty arises with the positive-
ness of the Wishart process. One can not assure that the discrete approximating
scheme remains in T
n
. One way to solve the problem it to rewrite the Wishart
process as a product of Ornstein-Uhlenbeck matrix processes thus ensuring posi-
tiveness and to approximate, through an Euler scheme, the Ornstein-Uhlenbeck
process. In the WASC the correlation between assets returns and their volatili-
ties is controlled by the vector therefore we need to reformulate the correlation
between the assets and the Ornstein-Ulhenbeck process. We turn to a more for-
mal presentation. It is an extension to our framework of the strategy developed
in Gourieroux et al. (2004).
We make the following hypothesis on the Gindikin coecient: N and >
n 1. Under this hypothesis and following equation (5.7) of Bru (1991) there
exists a matrix stochastic process X
t
in M
n
such that
t
= X

t
X
t
and whose
dynamics are given by
dX
t
= Mdt +dN
t

Q, (59)
with N
t
; t 0 a n matrix Brownian motion. The matrix Brownian motion
in equation (58) is related to equation (59) through d

W
t
=
_

1
t
X

t
dN
t
. As
the correlation in the WASC is dened between Z
t
; t 0 and

W
t
; t 0, we
turn our attention toward the problem of specifying it with respect to N
t
; t
0. Starting from the fact that dZ
k
t
d

W
ij
t
=
j

ki
dt for i, j, k = 1, . . . , n
8
and
dening
kj
t
; k, j = 1, . . . , n such that dZ
k
t
dN
ij
t
=
kj
t

ki
we conclude that
kj
t
=

j

n
l=0

kl
t
X
kl
t
where
(
ij
t
)
i,j=1..n
=
_
(X
t

X
t
)
(
ij
t
)
i,j=1..n
=
_

ij
t
_
1
i,j=1..n
.
From now on we formulate the problem with n = = 2 without loss of generality.
Using the denition of
kj
t
we have :
_

_
dN
11
t
=
11
t
dZ
1
t
+
12
t
d

Z
1
t
+
_
1 (
11
t
)
2
(
12
t
)
2
d

Z
1
t
dN
12
t
=
12
t
dZ
1
t

11
t
d

Z
1
t
+
_
1 (
12
t
)
2
(
11
t
)
2
d

Z
1
t
dN
21
t
=
21
t
dZ
2
t
+
22
t
d

Z
2
t
+
_
1 (
21
t
)
2
(
22
t
)
2
d

Z
2
t
dN
22
t
=
22
t
dZ
2
t

21
t
d

Z
2
t
+
_
1 (
22
t
)
2
(
21
t
)
2
d

Z
2
t
,
with

Z
t
; t 0,

Z
t
; t 0 and

Z
t
; t 0 three independent Brownian motions
(two dimensional vector). Combining the dynamics of the assets (1), (59),
t
=
8

ij
is the Kronecker function.
29
X

t
X
t
and the decomposition of N
t
with respect to Z
t
,

Z
t
,

Z
t
and

Z
t
, we obtain
that (Y
t
= log(S
t
), X
t
) satisfy the stochastic dierential equations system
_
dY
t
=
_

1
2
Vec((X

X)
ii
)
_
dt +
_
X

t
X
t
dZ
t
dX
t
= Mdt +
_
diag(dZ
t
)
t
+ diag(d

Z
t
)

t
+ diag(d

Z
t
)

t
+ diag(d

Z
t
)

t
_

Q.
Finally, in order to build an approximation of the above diusions in the spirit
of Nelson (1990), it is enough to discretize the above SDE, thus leading to the
announced stochastic dierence equations. Since the process X
t
is driven by
more noises than Y
t
, we then use the Hermite polynomials in order to generate
independent noises. In the case of = 0 we recover the result of Gourieroux et al.
(2004).
7.3 Dynamics of the correlation process
In this Appendix we compute in the 2-dimensional case the drift and the diusion
coecients of the correlation process
12
t
dened by

12
t
=

12
t
_

11
t

22
t
. (60)
The Wishart process
t
satises the following SDE:
d
t
= d
_

11
t

12
t

12
t

22
t
_
=
__

11

12

21

22
__

11

21

12

22
_
+
_
M
11
M
12
M
21
M
22
__

11
t

12
t

12
t

22
t
_
+
_

11
t

12
t

12
t

22
t
__
M
11
M
21
M
12
M
22
__
dt
+
_

11
t

12
t

12
t

22
t
_
1/2
_
dW
11
t
dW
12
t
dW
21
t
dW
22
t
__
Q
11
Q
12
Q
21
Q
22
_
+
_
Q
11
Q
21
Q
12
Q
22
__
dW
11
t
dW
21
t
dW
12
t
dW
22
t
__

11
t

12
t

12
t

22
t
_
1/2
.
Let be
_

11
t

12
t

12
t

22
t
_
:=
_

11
t

12
t

12
t

22
t
_
1/2
,
so that

2
t
=
t
=
_
(
11
t
)
2
+ (
12
t
)
2

11
t

12
t
+
12
t

22
t

11
t

12
t
+
12
t

22
t
(
12
t
)
2
+ (
22
t
)
2
_
. (61)
We rst compute the diusion coecient since it follows easily from the compu-
tations in the Appendix B of Da Fonseca et al. (2005). From the dynamics of the
30
Wishart process we have:
d
11
t
= (.)dt + 2
11
t
_
Q
11
dW
11
t
+Q
21
dW
12
t
_
+ 2
12
t
_
Q
11
dW
21
t
+Q
21
dW
22
t
_
,
d
12
t
= (.)dt +
11
t
_
Q
12
dW
11
t
+Q
22
dW
12
t
_
+
12
t
_
Q
12
dW
21
t
+Q
22
dW
22
t
_
+
12
t
_
Q
11
dW
11
t
+Q
21
dW
12
t
_
+
22
t
_
Q
11
dW
21
t
+Q
21
dW
22
t
_
,
d
22
t
= (.)dt + 2
12
t
_
Q
12
dW
11
t
+Q
22
dW
12
t
_
+ 2
22
t
_
Q
12
dW
21
t
+Q
22
dW
22
t
_
,
while the covariations are given by:
d
11
,
11
)
t
= 4
11
t
(Q
2
11
+Q
2
21
)dt,
d
12
,
12
)
t
=
_

11
t
_
Q
2
12
+Q
2
22
_
+ 2
12
t
(Q
11
Q
12
+Q
21
Q
22
) +
22
t
(Q
2
11
+Q
2
21
)
_
dt,
d
22
,
22
)
t
= 4
22
t
(Q
2
12
+Q
2
22
)dt,
d
11
,
12
)
t
=
_
2
11
t
(Q
11
Q
12
+Q
21
Q
22
) + 2
12
t
_
Q
2
11
+Q
2
21
__
dt,
d
11
,
22
)
t
= 4
12
t
(Q
11
Q
12
+Q
21
Q
22
) dt,
d
12
,
22
)
t
= 2
_

12
t
_
Q
2
12
+Q
2
22
_
+
22
t
(Q
11
Q
12
+Q
21
Q
22
)
_
dt.
Now we dierentiate both sides of the equality (
12
t
)
2
=
(

12
t
)
2

11
t

22
t
, thus obtaining
2
12
t
d
12
t
=
2
12
t

11
t

22
t
d
12
t
+
_

12
t
_
2
_
1

22
t
d
_
1

11
t
_
+
1

11
t
d
_
1

22
t
__
+ (.)dt,
so that
d
12
t
=
1
_

11
t

22
t
_
d
12
t


12
t
2
11
t
d
11
t


12
t
2
22
t
d
22
t
_
+ (.)dt.
By using the covariations among the Wishart elements we have
d

12
_
t
=
1

11
t

22
t
_

11
t
_
Q
2
12
+Q
2
22
_
+ 2
12
t
(Q
11
Q
12
+Q
21
Q
22
) +
22
t
_
Q
2
11
+Q
2
21
_
+
_

12
t
_
2
_
Q
2
11
+Q
2
21

11
t
+
Q
2
12
+Q
2
22

22
t
+ 2

12
t

11
t

22
t
(Q
11
Q
12
+Q
21
Q
22
)
_
2

12
t

11
t
_

11
t
(Q
11
Q
12
+Q
21
Q
22
) +
12
t
_
Q
2
11
+Q
2
21
__
2

12
t

22
t
_

12
t
_
Q
2
12
+Q
2
22
_
+
22
t
(Q
11
Q
12
+Q
21
Q
22
)
_
_
dt,
which leads to:
d

12
_
t
=
_
1
_

12
t
_
2
_
_
Q
2
12
+Q
2
22

22
t
+
Q
2
11
+Q
2
21

11
t
2

12
t
(Q
11
Q
12
+Q
21
Q
22
)
_

11
t

22
t
_
dt.
31
Now let us compute the drift of the process
12
t
.
We dierentiate both sides of the equality
12
t
=

12
t

11
t

22
t
and we consider the
nite variation terms:
d
12
t
=
1
_

11
t

22
t
d
12
t
+
12
t
d
_
1
_

11
t

22
t
_
+d
_

12
,
1

11

22
_
t
=
1
_

11
t

22
t
_

11

21
+
12

22
+M
21

11
t
+M
12

22
t
+ (M
11
+M
22
)
12
t
_
dt
+
12
t
_
_
1
_

22
t
_
_

1
2
_
(
11
t
)
3
_
_
_

2
11
+
2
12
+ 2M
11

11
t
+ 2M
12

12
t
_
+
1
_

11
t
_
_

1
2
_
(
22
t
)
3
_
_
_

2
21
+
2
22
+ 2M
21

12
t
+ 2M
22

22
t
_
+
3
8
_

11
t

22
t
(
11
t
)
2
d

11
_
t
+
3
8
_

11
t

22
t
(
22
t
)
2
d

22
_
t
+
1
4
_
(
11
t

22
t
)
3
d

11
,
22
_
t
_
_
dt +
1
_

22
t
_
_

1
2
_
(
11
t
)
3
_
_
d

11
,
12
_
t
+
1
_

11
t
_
_

1
2
_
(
22
t
)
3
_
_
d

12
,
22
_
t
+ Diusions.
Now we use the formulas of the covariations of the Wishart elements and we
arrive to an expression which can be written as follows:
d
12
t
=
_
A
t
_

12
t
_
2
+B
t

12
t
+C
t
_
dt + Diusions,
where
9
:
A
t
=
1
_

11
t

22
t
(Q
11
Q
12
+Q
21
Q
22
)

22
t

11
t
M
12

11
t

22
t
M
21
B
t
=

2
11
+
2
12
2
11
t


2
21
+
2
22
2
22
t
+
Q
2
11
+Q
2
21
2
11
t
+
Q
2
12
+Q
2
22
2
22
t
0
C
t
=
1
_

11
t

22
t
(
11

21
+
12

22
2 (Q
11
Q
12
+Q
21
Q
22
))
+

22
t

11
t
M
12
+

11
t

22
t
M
21
.
9
Notice that the diusion term and both the expressions for B
t
and C
t
are dierent from
the ones obtained by Buraschi et al. (2006).
32
From the denition of =

and the Gindikin condition we deduce that


B
t
is negative. As a by-product, we easily deduce the instantaneous covariation
between the Wishart element
11
t
and the correlation process:
d

12
,
11
_
t
=
1
_

11
t

22
t
_
d
11
,
12
)
t


12
t
2
11
t
d
11
,
11
)
t


12
t
2
22
t
d
22
,
22
)
t
_
= 2

11
t

22
t
_
1
_

12
t
_
2
_
(Q
11
Q
12
+Q
21
Q
22
) dt.
Using the fact that Q GL(n, R)
10
there exists a unique couple (K,

Q) O(n)
T
n
11
such that Q = K

Q. We refer to Faraut (2006) for basic results on matrix
analysis. The law of the
t
being invariant by rotation of Q we rewrite this
covariation as
d

12
,
11
_
t
= 2

11
t

22
t
_
1
_

12
t
_
2
_

Q
12
_

Q
11
+

Q
22
_
dt.
10
GL(n, R) is the linear group, the set of invertible matrices.
11
O(n) stands for the orthogonal group ie O(n) = g GL(n, R)[g

g = I
n
and T
n
is the
set of symmetric denite positive matrices.
33
R
h
o

1
S
u
p
p
o
r
t
F r e q u e n c y

0
.
2
0
.
0
0
.
2
0
.
4
0
.
6
0 5 0 1 0 0 1 5 0 2 0 0
R
h
o

2
S
u
p
p
o
r
t
F r e q u e n c y

0
.
2
0
.
0
0
.
2
0
.
4
0
.
6
0 5 0 1 0 0 2 0 0 3 0 0
S
k
e
w

f
o
r

a
s
s
e
t

1
S
u
p
p
o
r
t
F r e q u e n c y

0
.
6

0
.
4

0
.
2
0
.
0
0
.
2
0 5 0 1 0 0 1 5 0 2 0 0
S
k
e
w

f
o
r

a
s
s
e
t

2
S
u
p
p
o
r
t
F r e q u e n c y

0
.
6

0
.
4

0
.
2
0
.
0
0
.
2
0 5 0 1 0 0 1 5 0 2 0 0
F
i
g
u
r
e
1
:
E
s
t
i
m
a
t
e
d

(
t
o
p
)
a
n
d
s
k
e
w
(
b
o
t
t
o
m
)
f
r
o
m
D
C
C
e
s
t
i
m
a
t
i
o
n
o
f
t
h
e
W
A
S
C
.
R
e
a
l

g
u
r
e
s
a
r
e
i
n
r
e
d
a
n
d
D
C
C
-
b
a
s
e
d
e
s
t
i
m
a
t
e
d
o
n
e
s
a
r
e
i
n
b
l
u
e
.
T
h
e

g
u
r
e
d
i
s
p
l
a
y
s
t
h
e
e
s
t
i
m
a
t
e
d

p
a
r
a
m
e
t
e
r
(
t
o
p
)
a
n
d
s
k
e
w
(
b
o
t
t
o
m
)
i
n
a
t
w
o
a
s
s
e
t
s
c
a
s
e
.
W
e

r
s
t
s
i
m
u
l
a
t
e
d
a
W
A
S
C
m
o
d
e
l
i
n
w
h
i
c
h

=
(
.
5
,
.
5
)
.
W
e
t
h
e
n
e
s
t
i
m
a
t
e
d
t
h
e
D
C
C
-
b
a
s
e
d
t
i
m
e
v
a
r
y
i
n
g
c
o
v
a
r
i
a
n
c
e
m
a
t
r
i
c
e
s
.
F
i
n
a
l
l
y
t
h
e
s
k
e
w
i
s
e
s
t
i
m
a
t
e
d
b
y
u
s
i
n
g
e
q
u
a
t
i
o
n
(
7
)
a
n
d
(
8
)
.
B
y
d
e
n
o
t
i
n
g
t
h
e
s
k
e
w
v
e
c
t
o
r

0
=
(

0 1
,

0 2
)

,
t
h
e

v
e
c
t
o
r
i
s
e
s
t
i
m
a
t
e
d
b
y

=
_
Q

1
d
i
a
g
_
Q

Q
_

0
.
T
h
e
t
o
p

g
u
r
e
s
p
r
e
s
e
n
t
i
n
r
e
d
t
h
e
v
a
l
u
e
f
o
r

c
h
o
s
e
n
f
o
r
t
h
e
s
i
m
u
l
a
t
i
o
n
a
n
d
i
n
b
l
u
e
t
h
e
h
i
s
t
o
g
r
a
m
o
f
t
h
e
e
s
t
i
m
a
t
i
o
n
o
b
t
a
i
n
e
d
.
T
h
e
b
e
l
o
w

g
u
r
e
s
p
r
e
s
e
n
t
i
n
r
e
d
t
h
e
e
m
p
i
r
i
c
a
l
d
i
s
t
r
i
b
u
t
i
o
n
o
f
t
h
e
s
k
e
w
e
s
t
i
m
a
t
e
d
d
i
r
e
c
t
l
y
o
n
t
h
e
s
i
m
u
l
a
t
e
d
W
A
S
C
s
a
m
p
l
e
s
a
n
d
i
n
b
l
u
e
t
h
e
e
m
p
i
r
i
c
a
l
d
i
s
t
r
i
b
u
t
i
o
n
o
f
t
h
e
D
C
C
-
b
a
s
e
d
s
k
e
w
e
s
t
i
m
a
t
o
r
.
34
0 200 400 600 800 1000
0
.
5
1
.
0
1
.
5
2
.
0
2
.
5
Index
V
o
l
a
t
i
l
i
t
y
Time Varying Volatilities
0 200 400 600 800 1000
0
.
0
0
.
4
0
.
8
Index
C
o
r
r
e
l
a
t
i
o
n
Time Varying Correlation
Figure 2: Time varying (simulated) volatilities (top) and correlations
(bottom).
This gure displays simulated volatilities and correlation in the two dimen-
sional case (n = 2). The simulation has been produced using the parameters
used in the Monte Carlo experiments. Given
t
the dynamic covariance ma-
trix, the volatilities are
_

11
t
,
_

22
t
. The correlation is obtained by computing

12
t
/
_
_

11
t
+
_

22
t
_
.
35
w
300
200
100
0
100
200
300
w
300
200
100
0
100
200
300
O
b
j
e
c
t
i
v
e
0.02
0.04
0.06
0.08
0.10
Figure 3: Integrand of the C-GMM estimation criterion.
The gure displays the characteristic function with the integrated volatility pre-
sented in equation (29). The parameters used for to compute this characteristic
function are those used in the Monte Carlo experiments.
36
Daily Weekly
Number of obs. 500 1500 500 1500
M
11
Bias 0.0133 0.0382 0.227 0.0706
RMSE 1.5126 1.5213 1.529 1.6011
M
12
Bias -0.04 -0.014 -0.048 -0.036
RMSE 1.0136 1.0341 1.098 1.0896
M
21
Bias -0.056 -0.04 -0.085 -0.036
RMSE 0.981 1.0205 1.104 1.1101
M
22
Bias 0.1667 0.1784 0.070 0.0657
RMSE 1.5378 1.5502 1.511 1.5778
Q
11
Bias 0.1077 0.1069 0.132 0.1166
RMSE 0.088 0.0872 0.476 0.3568
Q
12
Bias 0.0309 0.0287 0.022 0.0208
RMSE 0.0664 0.0675 0.554 0.4467
Q
21
Bias -3E-04 -6E-04 -0.059 -0.008
RMSE 0.0876 0.0862 0.553 0.371
Q
22
Bias 0.0792 0.0772 0.057 0.0574
RMSE 0.0678 0.0661 0.455 0.4424
Bias 0.0632 -0.066 0.044 -0.107
RMSE 4.335 4.3472 4.546 4.4364

1
Bias 0.0055 -0.007 0.035 0.0268
RMSE 0.4617 0.4913 0.641 0.8031

2
Bias -0.004 0.0265 0.063 0.0445
RMSE 0.5231 0.4734 0.653 0.6405
Table 1: Results of the Monte Carlo experiments
This table displays the results for the Monte Carlo simulations performed using the following
parameters:

0
=
_
0.0225 0.0054
0.0054 0.0144
_
.M =
_
5 3
3 5
_
, =
_
0.3 0.4

, (62)
Q =
_
0.1133137 0.03335871
0.0000000 0.07954368
_
, = 15. (63)
Two dierent types of simulations are presented: one of the sample includes 500 daily observa-
tions and a second one uses 1500 daily observations, as in Carrasco et al. (2007).
SP500 FTSE DAX CAC 40
Min. :-0.128129 Min. :-0.141420 Min. :-0.197775 Min. :-0.149149
1st Qu.:-0.009940 1st Qu.:-0.010858 1st Qu.:-0.014283 1st Qu.:-0.015173
Median : 0.002491 Median : 0.002101 Median : 0.003727 Median : 0.002117
Mean : 0.001535 Mean : 0.001014 Mean : 0.001523 Mean : 0.001095
3rd Qu.: 0.013506 3rd Qu.: 0.013424 3rd Qu.: 0.019416 3rd Qu.: 0.018025
Max. : 0.123746 Max. : 0.135879 Max. : 0.171546 Max. : 0.166252
Table 2: Descriptive statistics for the real dataset.
The table summarizes the descriptive statistics for the available dataset. This dataset is made
of the SP500, FTSE, DAX and CAC time series, on a weekly sampling frequency. The dataset
starts on January 2nd 1990 and ends on June 30th 2007.
37
S
P
5
0
0
/
D
A
X
S
P
5
0
0
/
C
A
C
S
P
5
0
0
/
F
T
S
E
D
A
X
/
C
A
C
F
T
S
E
/
D
A
X
F
T
S
E
/
C
A
C
M
1
1
-
3
.
4
4
-
2
.
9
4
-
2
.
6
5
-
3
.
2
2
-
2
.
6
2
-
2
.
6
1
S
t
d
.
D
e
v
.
(
0
.
2
3
9
)
(
0
.
2
1
7
)
(
0
.
3
0
9
)
(
0
.
1
5
)
(
0
.
1
5
8
)
(
0
.
1
8
1
)
M
1
2
1
.
1
7
0
.
3
3
0
.
7
4
1
.
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