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Stock Returns Under Different Market Regimes: An Application of Markov Switching Models to 24 European Indices

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  • Anton Gerunov

Abstract

This paper studies the different modes of operation of European stock markets. Using data on 24 European indices over a period of 15 years, we show that these can be well represented by a Hidden Markov Model with two regimes that roughly correspond to bull and bear markets. We further estimate regime parameters and show that the alternate regimes have very different risk-return tradeoffs with clear implications for portfolio management. Corresponding transition probability matrices show the remarkable persistence of states and give a possible quantitative estimate of the degree of inertia in financial markets. Regime-switching coordination across markets is further examined, showing that moments of correlations are followed by idiosyncratic episodes and thus, risk diversification through regime arbitrage is possible.

Suggested Citation

  • Anton Gerunov, 2023. "Stock Returns Under Different Market Regimes: An Application of Markov Switching Models to 24 European Indices," Economic Studies journal, Bulgarian Academy of Sciences - Economic Research Institute, issue 1, pages 18-35.
    • Handle: RePEc:bas:econst:y:2023:i:1:p:18-35
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    References listed on IDEAS

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    1. Mariana Petrova & Teodor Todorov, 2023. "Empirical Testing of Models of Autoregressive Conditional Heteroscedasticity Used for Prediction of the Volatility of Bulgarian Investment Funds," Risks, MDPI, vol. 11(11), pages 1-30, November.

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    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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