We introduce a novel GARCH model that integrates two sources of uncertainty to better capture the rich, multi-component dynamics often observed in the volatility of financial assets. This model provides a quasi closed-form representation of the characteristic function for future log-returns, from which semi-analytical formulas for option pricing can be derived. A theoretical analysis is conducted to establish sufficient conditions for strict stationarity and geometric ergodicity, while also obtaining the continuous-time diffusion limit of the model. Empirical evaluations, conducted both in-sample and out-of-sample using S&P500 time series data, show that our model outperforms widely used single-factor models in predicting returns and option prices. The code for estimating the model, as well as for computing option prices, is made accessible in MATLAB language.1
Ballestra, L.V., D'Innocenzo, E., Tezza, C. (2026). A GARCH model with two volatility components and two driving factors. JOURNAL OF EMPIRICAL FINANCE, 85(February), 1-24 [10.1016/j.jempfin.2025.101671].
A GARCH model with two volatility components and two driving factors
Ballestra, Luca Vincenzo;D'Innocenzo, Enzo
;Tezza, Christian
2026
Abstract
We introduce a novel GARCH model that integrates two sources of uncertainty to better capture the rich, multi-component dynamics often observed in the volatility of financial assets. This model provides a quasi closed-form representation of the characteristic function for future log-returns, from which semi-analytical formulas for option pricing can be derived. A theoretical analysis is conducted to establish sufficient conditions for strict stationarity and geometric ergodicity, while also obtaining the continuous-time diffusion limit of the model. Empirical evaluations, conducted both in-sample and out-of-sample using S&P500 time series data, show that our model outperforms widely used single-factor models in predicting returns and option prices. The code for estimating the model, as well as for computing option prices, is made accessible in MATLAB language.1| File | Dimensione | Formato | |
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