What Tames the Celtic Tiger? Portfolio Implications from a Multivariate Markov Switching Model
FRB of St. Louis Working Paper No. 2006-029A
36 Pages Posted: 14 Jun 2006
Date Written: August 2007
We use multivariate regime switching vector autoregressive models to characterize the time-varying linkages among the Irish stock market, one of the top world performers of the 1990s, and the US and UK stock markets. We find that two regimes, characterized as bear and bull states, are required to characterize the dynamics of excess equity returns both at the univariate and multivariate level. This implies that the regimes driving the small open economy stock market are largely synchronous with those typical of the major markets. However, despite the existence of a persistent bull state in which the correlations among Irish and UK and US excess returns are low, we find that state comovements involving the three markets are so relevant to reduce the optimal mean-variance weight carried by ISEQ stocks to at most one-quarter of the overall equity portfolio. We compute time-varying Sharpe ratios and recursive mean-variance portfolio weights and document that a regime switching framework produces out-of-sample portfolio performance that outperforms simpler models that ignore regimes. These results appear robust to endogenizing the effects of dynamics in spot exchange rates on excess stock returns.
Keywords: international portfolio diversification, multivariate regime switching, national stock markets comovements, Sharpe ratios
JEL Classification: G11, F30, F37, C32
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