Bayesian Analysis of Stochastic Volatility Model using Finite Gaussian Mixtures with Unknown Number of Components

Abstract: Financial studies require volatility based models which provides useful insights on risks related to investments. Stochastic volatility models are one of the most popular approaches to model volatility in such studies. The asset returns under study may come in multiple clusters which are not captured well assuming standard distributions. Mixture distributions are more appropriate in such situations. In this work, an algorithm is demonstrated which is capable of studying finite mixtures but with unknown number of components. This algorithm uses a Birth-Death process to adjust the number of components in the mixture distribution and the weights are assigned accordingly. This mixture distribution specification is then used for asset returns and a semi-parametric stochastic volatility model is fitted in a Bayesian framework. A specific case of Gaussian mixtures is studied. Using appropriate prior specification, Gibbs sampling method is used to generate posterior chains and assess model convergence. A case study of stock return data for State Bank of India is used to illustrate the methodology.