Regime switching volatility calibration by the Baum-Welch method

Abstract

Regime switching volatility models provide a tractable method of modelling stochastic volatility. Currently the most popular method of regime switching calibration is the Hamilton filter. We propose using the Baum-Welch algorithm, an established technique from Engineering, to calibrate regime switching models instead. We demonstrate the Baum-Welch algorithm and discuss the significant advantages that it provides compared to the Hamilton filter. We provide computational results of calibrating and comparing the performance of the Baum-Welch and the Hamilton filter to S&P 500 and Nikkei 225 data, examining their performance in and out of sample.