A stochastic volatility model generates negative skewness when
A) The correlation between the stock return and changes in volatility is zero.
B) The correlation between the stock return and changes in volatility is negative.
C) The correlation between the stock return and changes in volatility is positive.
D) The volatility process exhibits mean-reversion.

Question

Quizplus · Accepted Answer

In a stochastic volatility model, negative correlation between the stock return and changes in volatility can result in negative skewness in the return distribution. This is because when volatility decreases, stock returns are more likely to have large positive deviations from the mean, while when volatility increases, stock returns are more likely to have small negative deviations from the mean. This leads to a distribution that is skewed to the left. Mean-reversion in the volatility process can also contribute to negative skewness, but this is not the only factor. Therefore, the correct answer is B.

A Stochastic Volatility Model Generates Negative Skewness When