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Market regimes, sectorial investments, and time-varying risk premiums

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Author Info

  • Peixin (Payton) Liu
  • Kuan Xu
  • Yonggan Zhao

Abstract

Purpose – This paper aims to extend the Fama and French (FF) three-factor model in studying time-varying risk premiums of Sector Select Exchange Traded Funds (ETFs) under a Markov regime-switching framework. Design/methodology/approach – First, the original FF model is augmented to include three additional macro factors – market volatility, yield spread, and credit spread. Then, the FF model is extended to a model with a Markov regime switching mechanism for bull, bear, and transition market regimes. Findings – It is found that all market regimes are persistent, with the bull market regime being the most persistent, and the bear market regime being the least persistent. Both the risk premiums of the Sector Select ETFs and their sensitivities to the risk factors are highly regime dependent. Research limitations/implications – The regime-switching model has a superior performance in capturing the risk sensitivities of the Sector Select ETFs, that would otherwise be missed by both the FF and the augmented FF models. Originality/value – This is the first research on Sector Select ETFs with Markov regime switching.

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Bibliographic Info

Article provided by Emerald Group Publishing in its journal International Journal of Managerial Finance.

Volume (Year): 7 (2011)
Issue (Month): 2 (April)
Pages: 107-133

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Handle: RePEc:eme:ijmfpp:v:7:y:2011:i:2:p:107-133

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Related research

Keywords: Compensation; Markov processes; Risk management; Time-varying control systems;

References

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  1. Simon van Norden & Huntley Schaller & ), 1995. "Regime Switching in Stock Market Returns," Econometrics 9502002, EconWPA.
  2. Keim, Donald B. & Stambaugh, Robert F., 1986. "Predicting returns in the stock and bond markets," Journal of Financial Economics, Elsevier, vol. 17(2), pages 357-390, December.
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  9. Timmermann, Allan, 2000. "Moments of Markov switching models," Journal of Econometrics, Elsevier, vol. 96(1), pages 75-111, May.
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  12. Andrew Ang & Geert Bekaert, 2002. "International Asset Allocation With Regime Shifts," Review of Financial Studies, Society for Financial Studies, vol. 15(4), pages 1137-1187.
  13. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June.
  14. Malcolm Baker & Jeffrey Wurgler, 1999. "The Equity Share in New Issues and Aggregate Stock Returns," Yale School of Management Working Papers ysm124, Yale School of Management, revised 01 Jan 2009.
  15. Pierre Collin-Dufresne, 2001. "The Determinants of Credit Spread Changes," Journal of Finance, American Finance Association, vol. 56(6), pages 2177-2207, December.
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Cited by:
  1. Chen, Zhiping & Li, Gang & Zhao, Yonggan, 2014. "Time-consistent investment policies in Markovian markets: A case of mean–variance analysis," Journal of Economic Dynamics and Control, Elsevier, vol. 40(C), pages 293-316.

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