Forecasting stock market volatility conditional on macroeconomic conditions

This paper presents a GARCH type volatility model with a time-varying unconditional volatility which is a function of macroeconomic information. It is an extension of the SPLINE GARCH model proposed by Engle and Rangel (2005). The advantage of the model proposed in this paper is that the macroeconomic information available (and/or forecasts) is used in the parameter estimation process. Based on an application of this model to S&P500 share index returns, it is demonstrated that forecasts of macroeconomic variables can be easily incorporated into volatility forecasts for share index returns. It transpires that the model proposed here can lead to signi…cantly improved volatility forecasts compared to traditional GARCH type volatility models. Keywords Volatility, macroeconomic data, forecast, spline, GARCH. JEL Classi…cation C12, C22, G00. Acknowledgements The authors would like to thank Roger Craine, Mardi Dungey, Rob Engle, Stan Hurn, Adrian Pagan, Ser-Huang Poon and seminar participants at the Queensland University of Technology, Manchester Business School and ESAM06 for their useful comments. Remaining errors are the responsibility of the authors. Corresponding author Ralf Becker CGBCR, Economics, School of Social Sciences University of Manchester, M13 9PL, UK email [email protected] Ph +44 161 275 4807, Fax +44 161 275 4812.