Regime Changes and Financial Markets
35 Pages Posted: 20 Jul 2011
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Regime Changes and Financial Markets
Regime Changes and Financial Markets
Regime Changes and Financial Markets
Regime Changes and Financial Markets
Date Written: July 2011
Abstract
Regime switching models can match the tendency of financial markets to often change their behavior abruptly and the phenomenon that the new behavior of financial variables often persists for several periods after such a change. While the regimes captured by regime switching models are identified by an econometric procedure, they often correspond to different periods in regulation, policy, and other secular changes. In empirical estimates, the regime switching means, volatilities, autocorrelations, and cross-covariances of asset returns often differ across regimes, which allow regime switching models to capture the stylized behavior of many financial series including fat tails, heteroskedasticity, skewness, and time-varying correlations. In equilibrium models, regimes in fundamental processes, like consumption or dividend growth, strongly affect the dynamic properties of equilibrium asset prices and can induce non-linear risk-return trade-offs. Regime switches also lead to potentially large consequences for investors' optimal portfolio choice.
Keywords: jumps, mixture distributions, non-linear equilibrium asset pricing models, rare events, regime switching
JEL Classification: G11, G12
Suggested Citation: Suggested Citation
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