Can VAR Models Capture Regime Shifts in Asset Returns? A Long-Horizon Strategic Asset Allocation Perspective
Federal Reserve Bank of St. Louis Working Paper No. 2010-002B
68 Pages Posted: 9 Jan 2010 Last revised: 1 Sep 2010
There are 2 versions of this paper
Can VAR Models Capture Regime Shifts in Asset Returns? A Long-Horizon Strategic Asset Allocation Perspective
Can VAR Models Capture Regime Shifts in Asset Returns? A Long-Horizon Strategic Asset Allocation Perspective
Date Written: August 24, 2010
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.
Keywords: Predictability, Strategic Asset Allocation, Markov Switching, Vector Autoregressive Models, Out-of-Sample Performance
JEL Classification: G11, C53
Suggested Citation: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
Consumption and Portfolio Decisions When Expected Returns are Time Varying
By John Y. Campbell and Luis M. Viceira
-
On the Predictability of Stock Returns: An Asset-Allocation Perspective
-
Who Should Buy Long-Term Bonds?
By John Y. Campbell and Luis M. Viceira
-
Who Should Buy Long-Term Bonds?
By John Y. Campbell and Luis M. Viceira
-
A Multivariate Model of Strategic Asset Allocation
By John Y. Campbell, Yeung Lewis Chan, ...
-
A Multivariate Model of Strategic Asset Allocation
By John Y. Campbell, Yeung Lewis Chan, ...
-
Dynamic Consumption and Portfolio Choice with Stochastic Volatility in Incomplete Markets
By George Chacko and Luis M. Viceira
-
Dynamic Consumption and Portfolio Choice with Stochastic Volatility in Incomplete Markets
By George Chacko and Luis M. Viceira