I've come across the term regime switch in volatilities when reading about the modelling of interest rates but could not find a definition for a regime switch and what a regime is.
Can somebody give an intuitive definition of a regime and a regime switch and provide examples?
Answer
The idea of regime switching in volatility is rooted in the observation that volatility is usually fairly consistent and "mild", and occasionally very high, say during a market crash. The concept goes further, though. Not only does the volatility level differ markedly in different regimes, but the behavior of volatility does as well (degree of mean reversion, shape of smile, term structure skew, etc). Many models use different regimes to allow the tuning of parameters under different regimes, then switching between regimes, to more accurately model observed behavior.
For an exploration for how market behavior can vary under different regimes: http://www.emanuelderman.com/writing/entry/regimes-of-volatility-risk-april-1999
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