Improving GARCH Volatility Forecasts

Many researchers use GARCH models to generate volatility forecasts. We show, however, that such forecasts are too variable. To correct for this, we extend the GARCH model by distinguishing two regimes with different volatility levels. GARCH effects are allowed within each regime, so that our model generalizes existing regime-switching models that allow for ARCH terms only. The empirical application on U.S. dollar exchange rates shows that our model indeed yields better volatility forecasts than single-regime GARCH and that the allowance for GARCH terms besides ARCH terms can be crucial for the forecast quality.

[1]  T. Bollerslev,et al.  Generalized autoregressive conditional heteroskedasticity , 1986 .

[2]  K. West,et al.  The Predictive Ability of Several Models of Exchange Rate Volatility , 1994 .

[3]  W. Newey,et al.  A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelationconsistent Covariance Matrix , 1986 .

[4]  W. Newey,et al.  Automatic Lag Selection in Covariance Matrix Estimation , 1994 .

[5]  Craig S. Hakkio,et al.  Market efficiency and cointegration: an application to the sterling and deutschemark exchange markets , 1989 .

[6]  T. Bollerslev,et al.  Answering the Critics: Yes, Arch Models Do Provide Good Volatility Forecasts , 1997 .

[7]  R. Engle.  Autoregressive conditional heteroscedasticity with estimates of the variance of United Kingdom inflation , 1982 .

[8]  Adrian Pagan,et al.  Alternative Models for Conditional Stock Volatility , 1989 .

[9]  H. White.  A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity , 1980 .

[10]  R. Chou,et al.  ARCH modeling in finance: A review of the theory and empirical evidence , 1992 .

[11]  James D. Hamilton,et al.  Autoregressive conditional heteroskedasticity and changes in regime , 1994 .

[12]  H. Iemoto.  Modelling the persistence of conditional variances , 1986 .

[13]  Stephen Gray.  Modeling the Conditional Distribution of Interest Rates as a Regime-Switching Process , 1996 .

[14]  James D. Hamilton.  A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle , 1989 .

[15]  W. Newey,et al.  A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelationconsistent Covariance Matrix , 1986 .

[16]  Christopher G. Lamoureux,et al.  Persistence in Variance, Structural Change, and the GARCH Model , 1990 .