A nesting framework for Markov-switching GARCH modelling with an application to the German stock market

Reher Gerrit; Wilfling Bernd

Abstract
In this paper, we establish a generalized two-regime Markov-switching GARCH model which enables us to specify complex (symmetric and asymmetric) GARCH equations that may differ considerably in their functional forms across the two Markov-regimes. We show how previously proposed collapsing procedures for the Markov-switching GARCH model can be extended to estimate our general specification by means of classical maximum-likelihood methods. We estimate several variants of the generalized Markov-switching GARCH model using daily excess returns of the German stock-market index DAX sampled during the last decade. Our empirical study has two major findings. First, our generalized model outperforms all nested specifications in terms of (a) statistical fit (when model selection is based on likelihood ratio tests), and (b) out-of-sample volatility forecasting performance. Second, we find significant Markov-switching structures in German stock-market data, with substantially differing volatility equations across the regimes.

Keywords
Markov-switching models; GARCH models; Dynamics of stock-index returns; Volatility forecasting