What Tames the Celtic Tiger? Portfolio Implications from a Multivariate Markov Switching Model

EFA 2006 Zurich Meetings Paper

FRB of St. Louis Working Paper No. 2006-029A

36 Pages Posted: 14 Jun 2006

See all articles by Stuart Hyde

Stuart Hyde

University of Manchester - Manchester Business School

Massimo Guidolin

Bocconi University - Department of Finance

Date Written: August 2007

Abstract

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

Suggested Citation

Hyde, Stuart and Guidolin, Massimo, What Tames the Celtic Tiger? Portfolio Implications from a Multivariate Markov Switching Model (August 2007). EFA 2006 Zurich Meetings Paper; FRB of St. Louis Working Paper No. 2006-029A. Available at SSRN: https://ssrn.com/abstract=900009 or http://dx.doi.org/10.2139/ssrn.900009

Stuart Hyde

University of Manchester - Manchester Business School ( email )

Booth Street West
Mezzanine Floor, Crawford House
Manchester M15 6PB
United Kingdom
44 (0) 161 275 4017 (Phone)
44 (0) 161 275 4023 (Fax)

Massimo Guidolin (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

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