Master thesis on the Volatility modelling

The purpose this master thesis is to find the most suitable volatility model that will fulfill all the stylized
facts about the volatility (volatility is not constant, there are volatility jumps, volatility clusters…). In the
introductory part we will discuss about the relationship between volatility trilogy (local volatility,
stochastic volatility and implied volatility). After creating each model we will try to obtain the volatility
smile and volatility surface.

The model to start with is the Geometric Brownian motion dS=µSdt+σSdz. The assumption that stock
price growths at the constant rate µ (while prices are not stationary, returns are generally stationary.
The Geometric Brownian equation consists of the two parts deterministic drift µSdt and a stochastic
diffusion σSdz. During this paper we will to improve the following two assumpions/facts of Geometric
Brownian motion volatility: volatility is constant, volatility increases with time. The second problem
(volatility that increases with time can be resolved by imposing mean reverting property into the
stochastic volatility equation.

Volatility modelling

In the Willey’s “The Volatility Smile” the authors start with modelling volatility with the Binomial model.
Basically at every time step there is a probability of for the Stock to go up (which we denote with p) and
to go down (1-p) -one minus probability of going up. Under the assumption that Stock price follows
Geometric Brownian motion the stock price must have have constant growth rate µ and a constant
variance σ. We have one more degree of freedom: we need to impose a condition for p. Authors
suggested following solutions : equal probability of up and down moves p=1/2 or u+d=0. We will try to
establish the probability p empirically. We will model the mean equation by the constant constant
continuous growth rate e^(r*t). Empirical curve will obviously deviate from our estimated curve. We will
estimate probability p by counting how many times our estimated curve was above the empirical curve.
Volatility in our case will be average deviation among the two curves multiplied by the Binomial random
variable with the probability parameter p.

In the second phase we will allow the p parameter and volatility parameter to vary across the given sample
based on the predefined number of clusters. In the jupyter notebook we tried to model the Apple stock. We
notice 3 clusters: first cluster with the low volatility (first 455 obs) second cluster where we constantly
overestimated the volatility (from 455 to 900 obs ) and the third cluster is the remaining 358 observation. We
will model sigma and p for each cluster. We notice that we managed to have varying volatility by allowing the
time intervals not be equal length/