Non-linear filtering with state dependant transition probabilities: A threshold (size effect) SV model

This paper considers the size effect, where volatility dynamics are dependant upon the current level of volatility within an stochastic volatility framework. A non-linear filtering algorithm is proposed where the dynamics of the latent variable is conditioned on its current level. This allows for the estimation of a stochastic volatility model where dynamics are dependant on the level of volatility. Empirical results suggest that volatility dynamics are in fact influenced by the level of prevailing volatility. When volatility is relatively low (high), volatility is extremely (not) persistent with little (a great deal of) noise.