Structural Breaks in Stock Returns Driven by Large Shocks
23 Pages Posted: 28 Sep 2013 Last revised: 30 Sep 2013
Date Written: September 26, 2012
This paper employes a parametric model of structural breaks in the mean of stock returns which allows them to be endogenously driven by large positive or negative stock market return shocks. These shocks can be taken to reflect important market announcements, monetary policy regime shifts and/or changes in business conditions which affect stock market. The model assumes that both the timing and size of breaks are stochastic. The last property of the model distinguishes it from models suggested in the literature to capture structural breaks or regime shifts in the mean of stock returns. Implementation of the model to the US stock market indicates that the model can successfully capture structural breaks in the mean of the aggregate return of this market. Most of these breaks are triggered by negative large return shocks. The latter can be of smaller magnitude that the positive ones. Finally, the paper shows that the model can be employed to successfully forecast future expected stock returns.
Keywords: expected returns, structural breaks, large shocks, state space model, regime-shifts, threshold models
JEL Classification: E32, C13, C22
Suggested Citation: Suggested Citation