Applying Exogenous Variables and Regime Switching To Multifactor Models on Equity Indices

Pawel Sakowski, Robert Ślepaczuk and Mateusz Wywiał
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Mateusz Wywiał: Faculty of Economic Sciences, University of Warsaw; Quedex Derivatives Exchange

No 2016-10, Working Papers from Faculty of Economic Sciences, University of Warsaw

Abstract: This article aims to extend the evaluation of classic multifactor models of Carhart(1997) for the case of global equity indices and to expand analysis performed in Sakowski, Slepaczuk, and Wywial (2015). Our intention is to test several modifications of these models to take into account different dynamics of equity excess returns between emerging and developed equity indices. Proposed extensions include volatility regime switching mechanism (using dummy variables and the Markov approach) and three new risk factors based on realized volatility of index returns, percentage deviation from nominal GDP trend and capitalisation relative to GDP factor. Additional modifications include introduction of common and country specific variables in order to control for global risk where fluctuations of volatility of various assets, prices of commodities, currencies and rates is really important. Moreover, instead of using data for individual stocks (which is a common approach in the literature), we evaluate the performance of these models for weekly data of 81 world investable equity indices in the period of 2000-2015. Such approach is proposed to estimate equity risk premium for a single country. Empirical evidence from the first part reveals important differences between results for classical models estimated on single stocks (either in international or US-only frame work) and models evaluated for equity indices. Additionally, we observe substantial discrepancies between results for developed countries and emerging markets. The last part of this research helps us to understand results revealed in the first part. Thanks to introduction of new risk factors, and additional common and country specific variables we were able to increase explanatory power of our factor models especially in case of emerging market indices. Finally, using weekly data for the last 15 years we illustrate importance of model risk and data overfitting effects when drawing conclusions upon results of multifactor models.

Keywords: multi-factor models; asset pricing models; equity risk premia; equity indices; new risk factors; sensitivity analysis; book to market; momentum; market price of risk; emerging and developed equity indices (search for similar items in EconPapers)
JEL-codes: C15 F30 G11 G12 G13 G14 G15 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2016
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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http://www.wne.uw.edu.pl/index.php/download_file/2554/ First version, 2016 (application/pdf)

Related works:
Journal Article: Applying exogenous variables and regime switching to multi-factor models on equity indices (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:war:wpaper:2016-10

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