Advanced Topics in Finance and Insurance

Financial risk drivers display empirical feature that deviate from the random walk. There are three main
empirical phenomenon:

• the first one is mean reversion that display fast decaying autocorrelations, and the model used to
address this issue is the ARMA (continuous state), instead in discrete state is the Markov chain (relevant
in credit);

• the second phenomenon is the long memory, also called slow decaying autocorrelation, it is relevant in
high frequency trading; the model used in this case is the fractional integration;

• the last phenomenon is volatility clustering, in which the volatility of the risk driver increments rather
than the increment themselves, display autocorrelation. The process used to model them in case of same
invariants is the GARCH, instead in case of different invariants is the stochastic volatility clustering.