Modeling long memory and regime switching with an MRS-FIEGARCH model: A simulation study

Recent research suggests that long memory can be caused by regime switching and is easily confused with it. However, if the causes of confusion were properly controlled, they could be distinguished. Motivated by this idea, our study aims to distinguish between the long memory and regime switching of financial volatility. We firstly modeled the long memory and regime switching of volatility using the Fractionally Integrated Exponential GARCH (FIEGARCH) and Markov Regime-Switching EGARCH (MRS-EGARCH) frameworks, respectively, and performed a simulation study on their finite-sample properties when innovations followed a non-normal distribution. Subsequently, we demonstrated the confusion between the FIEGARCH and MRS-EGARCH processes using simulations. A recent study theoretically proved that the time-varying smoothing probability series can induce the presence of significant long memory in the regime-switching process. To control for its effect, the two-stage two-state FIEGARCH and MRS-FIEGARCH frameworks are proposed. The Monte Carlo studies showed that both frameworks can effectively distinguish between the pure FIEGARCH and pure MRS-EGARCH processes. When the MRS-FIEGARCH model was further employed to fit series generated with the MRS-FIEGARCH process, it outperformed the ordinary FIEGARCH model. Finally, an empirical study of NASDAQ index return was conducted to demonstrate that our MRS-FIEGARCH model can provide potentially more reliable long-memory estimates, identify the volatility states and outperform both the FIEGARCH and MRS-EGARCH models.