Sudden changes in variance and volatility persistence in foreign exchange markets

Participants in the foreign exchange markets should be concerned with how a major event may lead to a sudden change in volatility as well as the role that shocks play in determining the persistence of volatility over time. This paper examines these issues by first identifying the time periods of sudden changes in volatility and then examining economic events surrounding those shifts. This research detects time periods of sudden changes in variance (i.e. regime shifts) by using the iterated cumulated sums of squares (ICSS) algorithm. Examining five major exchange rates from January 1990 to September 2000, it is found that accounting for volatility shifts in the GARCH model considerably reduces the persistence in volatility. The results suggest that many previous studies may have significantly overestimated the degree of volatility persistence that exists in financial time series.