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Specification analysis in regime-switching continuous-time diffusion models for market volatility

  • Ruijun Bu EMAIL logo , Jie Cheng and Kaddour Hadri
Published/Copyright: July 2, 2016

Abstract

We examine model specification in regime-switching continuous-time diffusions for modeling S&P 500 Volatility Index (VIX). Our investigation is carried out under two nonlinear diffusion frameworks, the NLDCEV and the CIRCEV frameworks, and our focus is on the nonlinearity in regime-dependent drift and diffusion terms, the switching components, and the endogeneity in regime changes. While we find strong evidence of regime-switching effects, models with a switching diffusion term capture the VIX dynamics considerably better than models with only a switching drift, confirming the presence and importance of volatility regimes. Strong evidence of nonlinear endogeneity in regime changes is also detected. Meanwhile, we find significant nonlinearity in the regime-dependent diffusion specification, suggesting that the nonlinearity in the VIX dynamics cannot be accounted for by regime-switching effects alone. Finally, we find that models based on the CIRCEV specification are significantly closer to the true data generating process of VIX than models based on the NLDCEV specification uniformly across all regime-switching specifications.

JEL Classification: C22; C24; C52; C58

Acknowledgments

The authors wish to thank all session participants at the 2nd International Workshop on Financial Markets and Nonlinear Dynamics (Paris, June 2015) for their constructive comments. Ruijun Bu gratefully acknowledges the financial support for his research from the ESRC through grant ES/J00622X/1 and the British Academy through grant SG131649.

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Supplemental Material:

The online version of this article (DOI: 10.1515/snde-2016-0047) offers supplementary material, available to authorized users.


Published Online: 2016-7-2
Published in Print: 2017-2-1

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