A part of a book
Switching Regime Volatility: An Empirical Evaluation.
Title of the book
Applied Quantitative Methods for Trading and Investment
Address of publication
Dunis C. L., Laws J., Naim P.
Markov switching models are one possible method to account for volatility clustering. This chapter aims at describing, in a pedagogical fashion, how to estimate a univariate switching model for daily foreign exchange returns which are assumed to be drawn in a Markovian way from alternative Gaussian distributions with different means and variances. An application shows that the US dollar/Deutsche Mark exchange rate can be modelled as a mixture of normal distributions with changes in volatility, but not in mean, where regimes with high and low volatility alternate. The usefulness of this methodology is demonstrated in a real life application, i.e. through the performance comparison of simple hedging strategies.
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