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The Number of Regimes Across Asset Returns: Identification and Economic Value

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Author Info

  • Mathieu Gatumel

    ()
    (CERAG - Centre d'études et de recherches appliquées à la gestion - CNRS : UMR5820 - Université Pierre-Mendès-France - Grenoble II)

  • Florian Ielpo

    ()
    (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris 1 - Panthéon-Sorbonne, Pictet Asset Management - Pictet Asset Management)

Abstract

A shared belief in the financial industry is that markets are driven by two types of regimes. Bull markets would be characterized by high returns and low volatility whereas bear markets would display low returns coupled with high volatility. Modeling the dynam- ics of different asset classes (stocks, bonds, commodities and currencies) with a Markov- Switching model and using a density-based test, we reject the hypothesis that two regimes are enough to capture asset returns' evolutions for many of the investigated assets. Once the accuracy of our test methodology has been assessed through Monte Carlo experi- ments, 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 high- light that taking into account the real number of regimes allows both improved portfolio returns and density forecasts.

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Bibliographic Info

Paper provided by HAL in its series Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) with number halshs-00658540.

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Date of creation: 2011
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Handle: RePEc:hal:cesptp:halshs-00658540

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Related research

Keywords: Bull and bear markets; Markov switching models; Number of regimes; Density based tests;

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