Shifts in volatility driven by large stock market shocks

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Abstract

This paper presents an extension of the stochastic volatility model which allows for level shifts in volatility of stock market returns, known as structural breaks. These shifts are endogenously driven by large return shocks (innovations), reflecting large pieces of market news. These shocks are identified from the data as being bigger in absolute terms than the values of two threshold parameters of the model: one for the negative shocks and one for the positive shocks. The model can be employed to investigate different sources of stock market volatility shifts driven by market news, without relying on exogenous information. In addition to this, it has a number of interesting features which enable us to study the effects of large return shocks on future levels of market volatility. The above properties of the model are shown based on a study for the US stock market volatility.

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Dendramis, Y., Kapetanios, G., & Tzavalis, E. (2015). Shifts in volatility driven by large stock market shocks. Journal of Economic Dynamics and Control, 55, 130–147. https://doi.org/10.1016/j.jedc.2015.03.006

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