Title: Analysing market volatility dynamics: Evidence from a latent factor-based regime-switching continuous-time model
Authors: Jie Cheng - Xi-an Jiaotong-Liverpool University (China) [presenting]
Ruijun Bu - The University of Liverpool (United Kingdom)
Abstract: Understanding the volatility dynamics is crucial for derivative pricing, financial investment, and risk management. We analyze the behavior of the S\&P 500 Volatility Index(VIX) by a novel latent-factor based regime-switching continuous-time approach. We assume that in each regime the VIX follows a continuous-time, nonlinear and non-Gaussian diffusion process and that the switching between regimes is driven by a latent time series potentially correlated with volatility shocks. Our focus is on the nonlinearity, long-run and short-run behaviors in the regime-dependent dynamics of the VIX, the endogeneity in regime changes, and finally the potential determinants of regime changes. Evidence from the VIX data at various frequencies all confirmed clear presence of endogenous regime-switching effects predominantly aecting the short-run behavior (i.e. the volatility) of VIX and also strong nonlinearity in its regime-dependent dynamics. To understand what is driving the regime changes and to what extent, we investigate the potential composition of the extracted regime-driving latent process by considering several regressions on a large dimension of market variables. Relying on several dimension reduction techniques, we find that as much as 40-65 percent of the variations in the latent process can be explained by observable economic and financial variables.