SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

Abstract: In this paper, we propose two parametric alternatives to the standard GARCH model. They allow the conditional variance to have a smooth time-varying structure of either additive or multiplicative type. The suggested parameterizations describe both nonlinearity and structural change in the conditional and unconditional variances where the transition between regimes over time is smooth. A modelling strategy for these new time-varying parameter GARCH models is developed. It relies on a sequence of Lagrange multiplier tests, and the adequacy of the estimated models is investigated by Lagrange multiplier type misspecification tests. Finite-sample properties of these procedures and tests are examined by simulation. An empirical application to daily stock returns and another one to daily exchange rate returns illustrate the functioning and properties of our modelling strategy in practice. The results show that the long memory type behaviour of the sample autocorrelation functions of the absolute returns can also be explained by deterministic changes in the unconditional variance.

Keywords: Conditional heteroskedasticity; Structural change; Lagrange multiplier test; Misspecification test; Nonlinear time series; Time-varying parameter model.

JEL-codes: C12; C22; C51; C52

56 pages, January 24, 2008

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