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Can VAR Models Capture Regime Shifts in Asset Returns? A Long-Horizon Strategic Asset Allocation Perspective


Massimo Guidolin


Bocconi University - Department of Finance

Stuart Hyde


University of Manchester - Manchester Business School

August 24, 2010

Federal Reserve Bank of St. Louis Working Paper No. 2010-002B

Abstract:     
We examine whether simple VARs can produce empirical portfolio rules similar to those obtained under a range of multivariate Markov switching models, by studying the effects of expanding both the order of the VAR and the number/selection of predictor variables included. In a typical stock bond strategic asset allocation problem on US data, we compute the out-of-sample certainty equivalent returns for a wide range of VARs and compare these measures of performance with those typical of non linear models that account for bull-bear dynamics and characterize the differences in the implied hedging demands for a long-horizon investor with constant relative risk aversion preferences. In a horse race in which models are not considered in their individuality but instead as an overall class, we find that a power utility investor with a constant coefficient of relative risk aversion of 5 and a 5-year horizon, would be ready to pay as much as 8.1% in real terms to be allowed to select models from the MS class, while analogous calculation for the whole class of expanding window VAR leads to a disappointing 0.3% per annum. We conclude that most (if not all) VARs cannot produce portfolio rules, hedging demands, or out-of-sample performances that approximate those obtained from equally simple non-linear frameworks.

Number of Pages in PDF File: 68

Keywords: Predictability, Strategic Asset Allocation, Markov Switching, Vector Autoregressive Models, Out-of-Sample Performance

JEL Classification: G11, C53

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Date posted: January 9, 2010 ; Last revised: September 1, 2010

Suggested Citation

Guidolin, Massimo and Hyde, Stuart, Can VAR Models Capture Regime Shifts in Asset Returns? A Long-Horizon Strategic Asset Allocation Perspective (August 24, 2010). Federal Reserve Bank of St. Louis Working Paper No. 2010-002B. Available at SSRN: http://ssrn.com/abstract=1533525 or http://dx.doi.org/10.2139/ssrn.1533525

Contact Information

Massimo Guidolin (Contact Author)
Bocconi University - Department of Finance ( email )
Via Roentgen 1
Milano, MI 20136
Italy
Stuart Hyde
University of Manchester - Manchester Business School ( email )
Booth Street West
Mezzanine Floor, Crawford House
Manchester M15 6PB
United Kingdom
44 (0) 161 275 4017 (Phone)
44 (0) 161 275 4023 (Fax)
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