Unstable volatility functions: the break preserving local linear estimator

The objective of this paper is to introduce the break preserving local linear (BPLL) estimator for the estimation of unstable volatility functions. Breaks in the structure of the conditional mean and/or the volatility functions are common in Finance. Markov switching models (Hamilton, 1989) and threshold models (Lin and Teräsvirta, 1994) are amongst the most popular models to describe the behaviour of data with structural breaks. The local linear (LL) estimator is not consistent at points where the volatility function has a break and it may even report negative values for finite samples. The estimator presented in this paper generalises the classical LL. The BPLL maintains the desirable properties of the LL with regard to the bias and the boundary estimation, it estimates the breaks consistently and it ensures that the volatility estimates are always positive.