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Specification analysis in regime-switching continuous-time diffusion models for market volatility

Author

Listed:
  • Bu Ruijun

    (Department of Economics, Finance and Accounting, Management School, University of Liverpool, Liverpool, UK, Phone: +44-151-795-3122, Fax: +44-151-795-3004)

  • Cheng Jie

    (Xi’an Jiaotong-Liverpool University, Department of Mathematical Sciences, Suzhou, Jiangsu, China)

  • Hadri Kaddour

    (Queen’s University Management School, Queen’s University Belfast, Belfast, UK)

Abstract

We examine model specification in regime-switching continuous-time diffusions for modeling S&P 500 Volatility Index (VIX). Our investigation is carried out under two nonlinear diffusion frameworks, the NLDCEV and the CIRCEV frameworks, and our focus is on the nonlinearity in regime-dependent drift and diffusion terms, the switching components, and the endogeneity in regime changes. While we find strong evidence of regime-switching effects, models with a switching diffusion term capture the VIX dynamics considerably better than models with only a switching drift, confirming the presence and importance of volatility regimes. Strong evidence of nonlinear endogeneity in regime changes is also detected. Meanwhile, we find significant nonlinearity in the regime-dependent diffusion specification, suggesting that the nonlinearity in the VIX dynamics cannot be accounted for by regime-switching effects alone. Finally, we find that models based on the CIRCEV specification are significantly closer to the true data generating process of VIX than models based on the NLDCEV specification uniformly across all regime-switching specifications.

Suggested Citation

  • Bu Ruijun & Cheng Jie & Hadri Kaddour, 2017. "Specification analysis in regime-switching continuous-time diffusion models for market volatility," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 21(1), pages 65-80, February.
    • Handle: RePEc:bpj:sndecm:v:21:y:2017:i:1:p:65-80:n:3
    DOI: 10.1515/snde-2016-0047
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    More about this item

    Keywords

    constant elasticity volatility; endogeneity; maximum likelihood estimation; nonlinear diffusion; regime-switching model; volatility index;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C24 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Truncated and Censored Models; Switching Regression Models; Threshold Regression Models
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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