Improving GARCH volatility forecasts with regime-switching GARCH |
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Authors: | Franc Klaassen |
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Institution: | (1) Department of Economics, University of Amsterdam, Roetersstraat 11, 1018 WB Amsterdam, the Netherlands (e-mail: klaassen@fee.uva.nl), NL |
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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.
First Version Received: November 2000/Final Version Received: August 2001 |
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Keywords: | : GARCH Markov-switching variance forecasting exchange rates |
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