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Improving GARCH volatility forecasts with regime-switching GARCH

Author

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  • Franc Klaassen

    () (Department of Economics, University of Amsterdam, Roetersstraat 11, 1018 WB Amsterdam, the Netherlands)

Abstract

Many researchers use GARCH models to generate volatility forecasts. Using data on three major U.S. dollar exchange rates we show that such forecasts are too high in volatile periods. We argue that this is due to the high persistence of shocks in GARCH forecasts. To obtain more flexibility regarding volatility persistence, this paper generalizes the GARCH model by distinguishing two regimes with different volatility levels; GARCH effects are allowed within each regime. The resulting Markov regime-switching GARCH model improves on existing variants, for instance by making multi-period-ahead volatility forecasting a convenient recursive procedure. The empirical analysis demonstrates that the model resolves the problem with the high single-regime GARCH forecasts and that it yields significantly better out-of-sample volatility forecasts.

Suggested Citation

  • Franc Klaassen, 2002. "Improving GARCH volatility forecasts with regime-switching GARCH," Empirical Economics, Springer, vol. 27(2), pages 363-394.
  • Handle: RePEc:spr:empeco:v:27:y:2002:i:2:p:363-394
    Note: Received: November 2000/Final Version Received: August 2001
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    More about this item

    Keywords

    GARCH; Markov-switching; variance; forecasting; exchange rates;

    JEL classification:

    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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