Chapter 10 Forecasting Stock Return Volatility in the Presence of Structural Breaks

We examine the role of structural breaks in forecasting stock return volatility. We begin by testing for structural breaks in the unconditional variance of daily returns for the S&P 500 market index and ten sectoral stock indices for 9/12/1989–1/19/2006 using an iterative cumulative sum of squares procedure. We find evidence of multiple variance breaks in almost all of the return series, indicating that structural breaks are an empirically relevant feature of return volatility. We then undertake an out-of-sample forecasting exercise to analyze how instabilities in unconditional variance affect the forecasting performance of asymmetric volatility models, focusing on procedures that employ a variety of estimation window sizes designed to accommodate potential structural breaks. The exercise demonstrates that structural breaks present important challenges to forecasting stock return volatility. We find that averaging across volatility forecasts generated by individual forecasting models estimated using different window sizes performs well in many cases and appears to offer a useful approach to forecasting stock return volatility in the presence of structural breaks.