School of Economics and Finance

No. 568: Stochastic Volatility Driven by Large Shocks

George Kapetanios , Queen Mary, University of London
Elias Tzavalis , Queen Mary, University of London

September 1, 2006

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This paper presents a new model of stochastic volatility which allows for infrequent shifts in the mean of volatility, known as structural breaks. These are endogenously driven from large innovations in stock returns arriving in the market. The model has a number of interesting properties. Among them, it can allow for shifts in volatility which are of stochastic timing and magnitude. This model can be used to distinguish permanent shifts in volatility coming from large pieces of news arriving in the market, from ordinary volatility shocks.

J.E.L classification codes: C22, C15

Keywords:Stochastic volatility, Structural breaks