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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

Massimo Guidolin

Bocconi University - Department of Finance

Stuart Hyde

University of Manchester - Manchester Business School

Multiple version iconThere are 2 versions of this paper

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

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: https://ssrn.com/abstract=1533525 or http://dx.doi.org/10.2139/ssrn.1533525

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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