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A Volatility Targeting GARCH model with Time-Varying Coefficients

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  • Thorsten Lehnert

    ()
    (Luxembourg School of Finance, University of Luxembourg)

  • Bart Frijns

    ()
    (Department of Finance, Auckland University of Technology, New Zealand)

  • Remco Zwinkels

    ()
    (Erasmus School of Economics, Erasmus University Rotterdam.)

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    Abstract

    GARCH-type models have been very successful in describing the volatility dynamics of financial return series for short periods of time. However, for example macroeconomic events may cause the structure of volatility to change and the assumption of stationarity is no longer plausible. In order 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. Estimation of this volatility targeting or VT-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.

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    Bibliographic Info

    Paper provided by Luxembourg School of Finance, University of Luxembourg in its series LSF Research Working Paper Series with number 09-08.

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    Date of creation: 2009
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    Handle: RePEc:crf:wpaper:09-08

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    Keywords: GARCH; time varying coefficients; multinomial logit;

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