Diffusion Limits of Real-Time GARCH

Ding, Y.

We prove that the diffusion limit of Real-Time GARCH (RT-GARCH) exists if we introduce an auxiliary process to state the system in a Markovian form. The volatility in the diffusion limit follows an Ornstein-Uhlenbeck-type process which fails to be positive with probability one. Moreover, only a degenerate diffusion limit can render an almost surely positive volatility process. As a result, we call for caution when using RT-GARCH since it lacks compatibility with existing asset pricing theories. The result also provides a new insight into how different specifications for GARCH affect its diffusion limit.