Forecasting stock volatility with economic policy uncertainty: A smooth transition GARCH-MIDAS model

Given that policy uncertainty shocks in the economic environment can exacerbate financial market volatility and pose financial risks, this paper utilizes a smooth transition version of the GARCH-MIDAS model to investigate the impact of different structural state changes in economic policy uncertainty (EPU) on stock market volatility. The extended model explains the nonlinear effects of the macro variables and the structural break changes in regime transitions. The empirical results confirm that the EPU indicators provide effective prediction information for stock volatility from the in-sample and out-of-sample analyses, which reveals that the smooth transition model provides an effective method for detecting the possible regime changes between stock volatility and macroeconomic uncertainty. Additionally, we further confirm that some category-specific EPU indicators also have strong smooth transition behaviour with respect to stock volatility. More important, our new model provides significant economic value to investors from a utility gain perspective. Overall, the institutional changes present in EPU play a nonnegligible and important role in stock market volatility. Accurate identification of the structural features of financial data helps investors deepen their understanding of the sources of stock market volatility. •Some category-specific EPU indices significantly affect stock market volatility.•There may be regime changes between stock volatility and macroeconomic uncertainty.•The ST-GARCH-MIDAS captures smooth changes of EPU for different stock volatility regimes.•The ST-GARCH-MIDAS model performs best under statistical and economic significance.