Regime Changes and Financial Markets

34 Pages Posted: 30 Aug 2011  

Andrew Ang

BlackRock, Inc

Allan G. Timmermann

University of California, San Diego (UCSD) - Department of Economics; Centre for Economic Policy Research (CEPR)

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Date Written: June 20, 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 identified by regime switching models are identified by an econometric procedure, they often intuitively match 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: regime switching, non-linear equilibrium asset pricing models, mixture distributions rare events, jumps

JEL Classification: G11, G12

Suggested Citation

Ang, Andrew and Timmermann, Allan G., Regime Changes and Financial Markets (June 20, 2011). Netspar Discussion Paper No. 06/2011-068. Available at SSRN: https://ssrn.com/abstract=1919497 or http://dx.doi.org/10.2139/ssrn.1919497

Andrew Ang (Contact Author)

BlackRock, Inc ( email )

55 East 52nd Street
New York City, NY 10055
United States

Allan G. Timmermann

University of California, San Diego (UCSD) - Department of Economics ( email )

9500 Gilman Drive
La Jolla, CA 92093-0508
United States
858-534-4860 (Phone)
858-534-7040 (Fax)

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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