A regime-switching model of stock returns with momentum and mean reversion

Javier Giner and Valeriy Zakamulin

Economic Modelling, 2023, vol. 122, issue C

Abstract: A vast body of empirical literature documents the existence of short-term momentum and medium-term mean reversion in various financial markets. However, few theoretical models explain these two common phenomena. A Markov model, wherein the return process randomly switches between bull and bear states, can reproduce many stylized facts of financial asset returns, excluding the mean reversion. An important limitation of the Markov model is that the state termination probability does not depend on age. We develop a semi-Markov model wherein, following the empirical evidence, the state termination probability increases with age. We demonstrate that this model induces short-term return momentum and subsequent reversal. We calibrate our model to real-world data and show that the empirical results agree with our theoretical model.

Keywords: Time-series momentum; Mean reversion; Bull and bear markets; Duration dependence; Semi-Markov model; Return autocorrelation function (search for similar items in EconPapers)
JEL-codes: C32 C51 G10 (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:122:y:2023:i:c:s0264999323000494

DOI: 10.1016/j.econmod.2023.106237

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