THE NUMBER OF REGIMES ACROSS ASSET RETURNS: IDENTIFICATION AND ECONOMIC VALUE

Mathieu Gatumel () and Florian Ielpo
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Mathieu Gatumel: University of Chambery, IREGE, 4 Chemin de Bellevue, BP 80439 74944, Annecy-le-Vieux Cedex, France

International Journal of Theoretical and Applied Finance (IJTAF), 2014, vol. 17, issue 06, 1-25

Abstract: A shared belief in the financial industry is that markets are driven by two types of regimes: bull markets, characterized by high returns and low volatility, and bear markets, characterized by low returns coupled with high volatility. Modeling the dynamics of different asset classes (stocks, bonds, commodities and currencies) with a Markov switching (MS) model and using a density-based test, we reject the hypothesis that two-regimes are enough to capture asset return evolutions for many of the investigated assets. Once the accuracy of our test methodology has been assessed through Monte Carlo experiments, our empirical results point out that between two and five regimes are required to capture the features of each asset's distribution. Moreover, we show that only a part of the underlying number of regimes is explained by the distributional characteristics of the returns such as kurtosis. A thorough out-of-sample analysis provides additional evidence that there are more than just bulls and bears in financial markets. Finally, we highlight that taking into account the real number of regimes allows both improved portfolio returns and density forecasts.

Keywords: Bull and bear markets; Markov switching models; number of regimes; density based tests (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (2)

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Working Paper: The Number of Regimes Across Asset Returns: Identification and Economic Value (2011)
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DOI: 10.1142/S021902491450040X

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