Modelling the structural break in volatility

Abstract

Recent studies suggest that US and other developed economies have become considerably stabilized in terms of volatility since the mid-1980s (Stock and Watson, 2002). This study models the structural break in volatility using a dynamic factor model with two state variables: one capturing cyclical fluctuations and another reflecting volatility decline. The new model confirms a one-time volatility reduction in the US economy in February 1984. Four-regime models appear to outperform two-regime models.

Notes

¹ The test statistic is equal 24.8 against a critical value of = 3.84.