A Flexible Regime Switching Model for Asset Returns

Marc S. Paolella, Pawel Polak and Patrick S. Walker
Additional contact information
Marc S. Paolella: University of Zurich - Department of Banking and Finance; Swiss Finance Institute
Pawel Polak: University of Zurich; Ecole Polytechnique Fédérale de Lausanne - Ecole Polytechnique Fédérale de Lausanne
Patrick S. Walker: University of Zurich, Department of Banking and Finance

No 19-27, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: A non-Gaussian multivariate regime switching dynamic correlation model for fi nancial asset returns is proposed. It incorporates the multivariate generalized hyperbolic law for the conditional distribution of returns. All model parameters are estimated consistently using a new two-stage expectation-maximization algorithm that also allows for incorporation of shrinkage estimation via quasi-Bayesian priors. It is shown that use of Markov switching correlation dynamics not only leads to highly accurate risk forecasts, but also potentially reduces the regulatory capital requirements during periods of distress. In terms of portfolio performance, the new regime switching model delivers consistently higher Sharpe ratios and smaller losses than the equally weighted portfolio and all competing models. Finally, the regime forecasts are employed in a dynamic risk control strategy that avoids most losses during the fi nancial crisis and vastly improves risk-adjusted returns.

Keywords: sGARCH; Markov Switching; Multivariate Generalized Hyperbolic Distribution; Portfolio Optimization; Value-at-Risk (search for similar items in EconPapers)
JEL-codes: C32 C51 C53 G11 G17 G32 (search for similar items in EconPapers)
Pages: 52 pages
Date: 2019-05, Revised 2019-05
New Economics Papers: this item is included in nep-ecm, nep-ore and nep-rmg
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1927

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