34 Pages Posted: 30 Aug 2011
Date Written: June 20, 2011
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: 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