A stochastic volatility model with Markov switching

This article presents a new way of modeling time-varying volatility. We generalize the usual stochastic volatility models to encompass regime-switching properties. The unobserved state variables are governed by a first-order Markov process. Bayesian estimators are constructed by Gibbs sampling. High-, medium- and low-volatility stares are identified for the Standard and Poor's 500 weekly return data. Persistence in volatility is explained by the persistence in the low-and the medium-volatility states. The high-volatility regime is able to capture the 1987 crash and overlap considerably with four U.S. economic recession periods