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Rational bubble, short-dated volatility forecasting and extract more from the volatility surface

Wang, Yiyi (2011) Rational bubble, short-dated volatility forecasting and extract more from the volatility surface. PhD thesis, London School of Economics and Political Science.

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The thesis covers three main chapters. The first chapter (which is a joint work) we develop a theoretical model of rational bubble. In equilibrium, a bubble can persist until it bursts following an exogenous shock, even when all the agents are aware of the bubble and that it will burst in finite time. Applying the model in the context of the sub-prime mortgage crisis, we argue that excessive sub-prime lending behaviour may be sensible with the introduction of securitization. We thus provide a rational explanation for the housing bubble and the dramatic increase in sub-prime default rates. In the second chapter I conduct empirical short-dated volatility forecasting in foreign exchange, and carry out a realistic volatility swap trading strategy based on the forecast. Additional to applying regime-switch technique, I propose a double-step approach to circumvent the disadvantage of employing GARCH-type model in the high frequency data in FX market, so that it can separate the effect of intraday/intraweek seasonality and pre-scheduled macroeconomic data releases from the underlying data process. By keeping a battery of models and rotating among them, the forecast ability gets significantly enhanced and the trading profit is pronounced even after considering transaction cost. In the third chapter I explore the cross-sectional predictive power of the most important two factors in the implied volatility surface - skew and term structure - at individual firm level. Stocks with lower implied volatility skew and higher implied volatility term structure outperform the comparative peers. In particular, the interaction between these two factors reinforces the predictive power, and the return of a weekly long- short strategy can be improved greatly with the attachment of term structure on skew. By sorting firms based on skew and term structure one may also be able to pick up takeover targets and seize the big positive premium.

Item Type: Thesis (PhD)
Additional Information: © 2011 Yiyi Wang
Library of Congress subject classification: H Social Sciences > HG Finance
Sets: Departments > Finance
Supervisor: Polk, Christopher

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