Regime-Switching and the Estimation of Multifractal Processes
42 Pages Posted: 7 Nov 2008
Date Written: March 2002
We propose a discrete-time stochastic volatility model in which regime-switching serves three purposes. First, changes in regimes capture low frequency variations, which is their traditional role. Second, they specify intermediate frequency dynamics that are usually assigned to smooth autoregressive processes. Finally, high frequency switches generate substantial outliers. Thus, a single mechanism captures three important features of the data that are typically addressed as distinct phenomena in the literature. Maximum likelihood estimation is developed and shown to perform well in finite sample. We estimate on exchange rate data a version of the process with four parameters and more than a thousand states. The estimated model compares favor-ably to earlier specifications both in- and out-of-sample. Multifractal forecasts slightly improve on GARCH(1,1) at daily and weekly inter-vals, and provide considerable gains in accuracy at horizons of 10 to 50 days.
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