Modeling structural changes in the volatility process

Bart Frijns, Thorsten Lehnert, Remco C J Zwinkels*

*Corresponding author for this work

Research output: Contribution to JournalArticleAcademicpeer-review

Abstract

GARCH-type models have been very successful in describing the volatility dynamics of financial return series for short periods of time. However, the time-varying behavior of investors, for example, may cause the structure of volatility to change and the assumption of stationarity is no longer plausible. To deal with this issue, the current paper proposes a conditional volatility model with time-varying coefficients based on a multinomial switching mechanism. By giving more weight to either the persistence or shock term in a GARCH model, conditional on their relative ability to forecast a benchmark volatility measure, the switching reinforces the persistent nature of the GARCH model. The estimation of this benchmark volatility targeting or BVT-GARCH model for Dow 30 stocks indicates that the switching model is able to outperform a number of relevant GARCH setups, both in- and out-of-sample, also without any informational advantages.

Original languageEnglish
Pages (from-to)522-532
Number of pages11
JournalJournal of Empirical Finance
Volume18
Issue number3
DOIs
Publication statusPublished - Jun 2011

Keywords

  • GARCH
  • Multinomial logit
  • Time varying coefficients

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