This study applies various regime switching gjrgarch models to analyze the effects of macroeconomic variables interest rate, dividend yield, and default premium on stock return movements including conditional mean, conditional variance, and transition probabilities in the. We consider forecast horizons of 1, 5, 10, 20, 50 and 100 days. Thus, the drift term in 1 has the effect of mean reversion. Lo 1987 derived tightbound on the prices of a european call option given the. For comparison purposes, the single regime model in eq. A flexible regime switching model with pairs trading. Furthermore, when analyzing contributions of the two regimes we find that the indication of mean reversion is due to the recent high returnhigh volatility regime only. In our approach, the mean or volatility process is switched between two regimes, depending upon. A moment approach to pricing exotic options under regime. To decompose the stock returns of the gcc stock markets into permanent and transitory. Do macroeconomic variables have regimedependent effects. Regime switching in mean reverting stochastic process. The model identifies two regimes which have low return low volatility and high return high volatility, respectively.
The timevarying coefficients with markovswitching variance model. A practical application of regime switching models to pairs. The low return low volatility regime dominated, except in a few, short episodes, until the beginning of the 70s whereas the 80s and 90s have been. Regime switching models move between states within the sample. Pdf a regimeswitching model of longterm stock returns. Does herding behavior exist in chinese stock markets. Evaluating the building blocks of a dynamically adaptive. Regime switching garch mrsgarch models, where the parameters are allowed to switch between a low and a high volatility regime, are analyzed. Regimeswitching stock returns and mean reversion core. Regime switching might be an approach to pairs trading. Stock loan valuation under a regimeswitching model with mean. For each model, the dependent variable is one period return. Regime switching modelwith endogenous autoregressive. A practical application of regime switching models to.
Gauss programs to accompany chapter 9 236 references 236 10 statespace models with markov switching and gibbssampling 237 10. Tom starke for providing the inspiration for this article series. Hence, the contribution to the loglikelihood of the tth observation is log fy tuy. The low return low volatility regime dominated, except in a few, short episodes, until the beginning of the 70s whereas the 80s and 90s have been characterized by high return and high volatility. Threeyear returns showed a negative correlation of 25%, while 5year returns showed a negative correlation of 40%. Is regime switching in stock returns important in portfolio decisions.
Stock returns, volatility and mean reversion in emerging and. Active portfolio management in the andean countries stock markets with markovswitching garch. A moment approach to pricing exotic options under regimeswitching 3 jumpdi. A threestate markov switching mean variance model of the real interest rate 229 appendix. Mean returns and volatility in the nikkei index, 19702000 mean stock market return mean volatility 19701980 11. Using this test procedure we find mean reversion at 10% but not at 5%. The author is grateful for many helpful comments from david a.
Since then, the use of the regimeswitching method for modelling dynamics and asymmetries in stock market returns has become very popular and the variety of di. To tackle this problem, we use the autoregression test of mean reversion based on the gibbssamplingaugmented randomization methodology. A stock price may, say, be determined by and correlated to the main equity index when it has a large market capitalisation and then by a subindex when its relative size shrinks consider apple. What drives markov regime switching behavior of stock. The property of mean reversion is also distinct from the property of moving in cycles. Building on the seminal work of hamilton 1989 regimeswitching methods have been widely used in a variety of contexts.
Propose a markov regime switching on the rate of the jumps in a mean reverting jumpdiffusion model. We estimate a wellspecified twostate regimeswitching model for danish stock returns. Estimating the parameters of a meanreverting markov. Study various models that characterize the stochastic behavior of the commodity spot prices. Section 3 derives analytical means and variances of the model and tests hypotheses. Regime switching modelwith endogenous autoregressive latent factor. As an example, regime switching lognormal models move randomly between boom and bust cycles, with higher average returns in boom cycles following lower average returns in bust cycles. For a twostate markov regimeswitching model, the strategy sometimes gives better performance, since it tends to outperform the buyandhold strategy only in the lowmean state. These models have an analytic solution that requires the numerical integration of complex functions. T rading vix futures under mean reversion with regime switching. Sophisticated meanreversion jumpdiffusion models for spot prices incorporate multiple jump processes, regimeswitching, and stochastic volatility deng, 1999. Aug 24, 2018 regime switching might be an approach to pairs trading.
As an example, regimeswitching lognormal models move randomly between boom and bust cycles, with higher average returns in boom cycles following lower average returns in bust cycles. Introduction traditional models for stock returns, including the original blackscholes approach, assume that returns follow a geometric brownian motion. Both gaussian and fattailed conditional distributions for the residuals are assumed, and the degrees of freedom can. Opt a threestate markovswitching variance model of stock returns. Hamilton and susmel 6 stated that the spurious high persistence problem in garch type models can be solved by combining the markov regime switching mrs model with arch models swarch. First, price movements not related to the effects of markovswitching. Volatility and mean reversion in emerging and developed financial markets.
This study applies various regime switching gjrgarch models to analyze the effects of macroeconomic variables interest rate, dividend yield, and default premium on stock return movements including conditional mean, conditional variance, and transition probabilities in the u. Pdf stock returns, volatility and mean reversion in emerging. Do macroeconomic variables have regimedependent effects on. However, finnerty and leistikow 1993 model ex post risk premium of various asset classes as a mean reverting process, and find that. Estimate the parameters of a meanreverting jumpdiffusion model using the maximum likelihood method. Opt a threestate markov switching mean variance model of the real interst rate. Statespace models with regime switching classical and gibbs. In this paper i first define the regimeswitching lognormal model. The code below is a modification of that which used to be found on his website, which later became. In the previous post i outlined some of the available techniques used for modeling market states. Mean reversion, on the other hand, seems to get very little attention. February, 2010 1this paper previously circulated with the title, \are bull and bear markets economically important. A 2state markov model can explain up to 65% variations and nonnormality in the returns process. The following section fits a regime switching model to our return data.
Stock returns, volatility and mean reversion in emerging and developed financial markets. The idea behind using the regime switching models to identify market states is that market returns might have been drawn from 2 or more distinct distributions. In general, our results indicated that bitcoin is mean averting for different returns horizons, model specifications and for subsample periods, which show the explosive characteristic of the bitcoin in the. There are a few other analytical studies of stoploss strategies. Propose a markov regime switching on the rate of the jumps in a meanreverting jumpdiffusion model. No attempt has been made to examine the mean reversion of the two components that make up the returns of these gcc markets while allowing for volatility regime switching. Trading vix futures under mean reversion with regime switching. In this paper i first define the regime switching lognormal model. Both gaussian and fattailed conditional distributions for the residuals are assumed, and the degrees of freedom can be statedependent to model possible timevarying kurtosis. Forecasting stock market volatility with regimeswitching.
The spread between onemonth and threemonth futures prices is an important determinant in the dynamics of crude oil prices. As a base case, for example, we may suppose that market returns are samples from one normal distribution nmu, sigma i. Pdf stock returns, volatility and mean reversion in. While mean reversion itself may not be treated as a myth, most model builders avoid any mean reversion feature in their simulations of stock returns. Estimate the parameters of a mean reverting jumpdiffusion model using the maximum likelihood method.
The idea of using the underlying moment structure to derive bounds for option pricing in fact has some history see, e. Gauss programs to accompany chapter 4 93 references 93 5 statespace models with markov switching 97 5. Volatility regimeswitching and linkage among gcc stock m arkets. Pdf trading vix futures under mean reversion with regime. Is regime switching in stock returns important in portfolio. Testing for mean reversion in bitcoin returns with gibbs. Basics of statistical mean reversion testing id like to thank dr. Pdf the objective of this research is to measure and examine. In particular, investors often use available realized returns at a given point in time to determine whether the market is in a bull or a bear state. Tailvar risk measures are derived, and a numerical example compares the regime switching lognormal model results with those using the more traditional lognormal stock return model. In their model, the process of regime switching is.
Numerous authors have suggested that the priceearnings pe ratio can be used to predict the future movement of stock prices. The model identifies two regimes which have low returnlow volatility and. Opt an ar4 model with a markovswitching mean 2state and timevarying transition probabilities. Evidence and implications, nber working papers 2343, national bureau of economic research, inc. Numerical examples are reported to illustrate the results.
Monthly data from the standard and poors 500 and the toronto stock exchange 300 indices are used to fit the model parameters. Regimeswitching garch mrsgarch models, where the parameters are allowed to switch between a low and a high volatility regime, are analyzed. Investors therefore tend to decompose market uctuations into bull and bear markets. Regime switching in stock market returns ideasrepec. In a formal sense, regimeswitching econometric models refer to a situation in which stock market. A threestate markov switching meanvariance model of the real interest rate 229 appendix. To forecast plan bond returns, consider modeling the term structure of both real and nominal interest rates. The major motivation for the present research program is to develop such a benchmark for lifetime financial. Citeseerx regimeswitching stock returns and mean reversion. The key intuition is that an ambiguityaverse agent behaves pessimistically by attaching more. This paper provides a bayesian framework for making portfolio decisions that takes this regime switching into account, together with asset pricing model uncertainty and parameter uncertainty. Opt a threestate markov switching variance model of stock returns. Conversely, models of predictable, meanreverting returns imply. For a twostate markov regime switching model, the strategy sometimes gives better performance, since it tends to outperform the buy and hold strategy only in the low mean state.
Statespace models with regime switching classical and. The stock market goes through periods during which equity prices persistently rise or fall. Similarly, serial correlation and implications for mean reversion is considered in section 4. Citeseerx document details isaac councill, lee giles, pradeep teregowda. This paper will list, prove, and analyze formulas for stock loan valuation with finite horizon under various stock models, including classical geometric brownian motion, mean reverting, and twostate regime switching with both mean reverting and geometric brownian motion states. Forecasting volatility of gold price using markov regime.
We propose an alternative test of mean reversion which allows for multiple regimes with potentially different constant and autoregressive terms and. The stock market displays regime switching between upturns and downturns. Optimal arbitrage strategies on stock index futures. Whaley 20 have also illustrated the negative returns associated with vix futures and. Such arguments are based on the belief that pe ratios are meanreverting.
Pdf this paper studies the optimal vix futures trading problems under a. This model was originally studied by goutte 27 for the pricing and hedging of derivatives. A striking feature is that the modied rls model has the smallest mean square forecast errors in 64 out of the 72 cases, while it is a close second for the other 8 cases. T o price futures, we assume a reparametrized cir mo del for the riskneutral vix dynamics. Regime switching in stock market returns citeseerx. Simple technical trading rules and the stochastic properties of stock returns, journal of finance, american finance association, vol. The low return low volatility regime dominated, except in a few, short episodes, until the beginning of the 70s. They used a deterministic regime switching model by identifying the specific official date when each market switches from one regime i. Regime switching enables a very powerful dynamic regression analysis of time series by incorporating both of these periods. Basics of statistical mean reversion testing quantstart. Regime switching stock returns and mean reversion, working papers 112000, copenhagen business school, department of economics. However several people have questioned whether these results actually establish the existence of longterm mean reversion. Dynamic portfolio choice under ambiguity and regime switching.
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