5. Conclusion
This study examines nonlinearities in the dynamics of market volatility implied in
options prices in the Japanese and US markets. The analysis tests for regime switches in
volatility expectations using the CBOE new VIX index and a similarly computed index
from Nikkei 225 options prices, not available in economic databases. The characterization
of these regimes is based on a set of conditioning variables, which includes past returns and
realized volatility. The first-order Markov regime-switching models test also for the
asymmetric impact of news and the presence of an adjustment mechanism through which
volatility expectations respond to the dynamics of realized volatility. The testing approach
allows also for the examination of regime switches in volatility expectations in association
with financial crises.
The empirical evidence with respect to implied volatility levels suggests that the
regime governing volatility expectations in the US market features a long memory process,
and relatively less significant leverage effects. The prevailing regime in the Japanese market
is characterized by expectations of low volatility levels, longer memory and significant
leverage effects. These results indicate that market volatility is expected to be higher in bear
periods and lower in bull periods and that leverage effects constitute an important source of
nonlinearities in expectations of market volatility. Given the evidence of positive serial
correlation, the expected level of volatility in both markets is not likely to be so much
whittled down by mean reversion as by leverage effects.
There is also evidence from the first differences in implied volatility that the
prevailing regime for the rate of change in expected volatility in the US market is likely to
be characterized by significant mean reversion, weaker asymmetric impact of news, and
positive, albeit less significant, adjustment to changes in realized volatility. The dynamics of
volatility expectations in the Japanese market are likely to be driven by a regime of
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