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Modelling structural changes in the volatility process

  • Thorsten Lehnert


    (Luxembourg School of Finance, University of Luxembourg)

  • Bart Frijns

    (Department of Finance, Auckland University of Technology)

  • Remco C.J. Zwinkels


    (Erasmus School of Economics)

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 benchmark volatility targeting or BVTGARCH 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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Paper provided by Luxembourg School of Finance, University of Luxembourg in its series LSF Research Working Paper Series with number 10-05.

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Date of creation: 2010
Date of revision:
Handle: RePEc:crf:wpaper:10-05
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  1. Peter Christoffersen & Kris Jacobs, 2004. "Which GARCH Model for Option Valuation?," Management Science, INFORMS, vol. 50(9), pages 1204-1221, September.
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