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Association between Markov regime-switching market volatility and beta risk: Evidence from Dow Jones industrial securities

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  • Don U.A. Galagedera

    (Monash University)

  • Roland Shami

    (Monash University)

Abstract

In this paper, the volatility of the return generating process of the market portfolio and the slope coefficient of the market model is assumed to follow a Markov switching process of order one. The results indicate very strong evidence of volatility switching behaviour in a sample of returns in the S&P500 index. In three of the thirty securities in the Dow Jones index, the estimated slope in the market model show strong switching behaviour. In these three securities the low risk state is more persistent than the high-risk state. For each security we estimate the conditional probabilities that the security is in the high (low) risk state given the market is in the high (low) volatility regime and show that this information can be used to classify securities into three distinct groups. There is no association between these groups and the securities' constant beta estimated in the market model and the Sharpe index. Some directions for further research are discussed.

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Bibliographic Info

Paper provided by EconWPA in its series Finance with number 0406011.

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Length: 27 pages
Date of creation: 23 Jun 2004
Date of revision:
Handle: RePEc:wpa:wuwpfi:0406011

Note: Type of Document - pdf; pages: 27
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Web page: http://128.118.178.162

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Keywords: Asset pricing; Markov regime-switching; market volatility; beta risk;

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  1. Goodwin, Thomas H, 1993. "Business-Cycle Analysis with a Markov-Switching Model," Journal of Business & Economic Statistics, American Statistical Association, vol. 11(3), pages 331-39, July.
  2. Fabozzi, Frank J & Francis, Jack Clark, 1977. "Stability Tests for Alphas and Betas over Bull and Bear Market Conditions," Journal of Finance, American Finance Association, vol. 32(4), pages 1093-99, September.
  3. G. William Schwert, 1990. "Business Cycles, Financial Crises, and Stock Volatility," NBER Working Papers 2957, National Bureau of Economic Research, Inc.
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  7. repec:bla:jbfnac:v:25:y:1998:i:5&6:p:721-745 is not listed on IDEAS
  8. Gooding, Arthur E. & O'Malley, Terence P., 1977. "Market Phase and the Stationarity of Beta," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(05), pages 833-857, December.
  9. Chen, Son-Nan, 1982. "An Examination of Risk-Return Relationship in Bull and Bear Markets Using Time-Varying Betas," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 17(02), pages 265-286, June.
  10. Bos, T & Newbold, P, 1984. "An Empirical Investigation of the Possibility of Stochastic Systematic Risk in the Market Model," The Journal of Business, University of Chicago Press, vol. 57(1), pages 35-41, January.
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  12. Huntley Schaller & Simon Van Norden, 1997. "Regime switching in stock market returns," Applied Financial Economics, Taylor & Francis Journals, vol. 7(2), pages 177-191.
  13. Ho-Chuan Huang, 2000. "Tests of regimes - switching CAPM," Applied Financial Economics, Taylor & Francis Journals, vol. 10(5), pages 573-578.
  14. Tim Bollerslev, 1986. "Generalized autoregressive conditional heteroskedasticity," EERI Research Paper Series EERI RP 1986/01, Economics and Econometrics Research Institute (EERI), Brussels.
  15. William F. Sharpe, 1965. "Mutual Fund Performance," The Journal of Business, University of Chicago Press, vol. 39, pages 119.
  16. R.W. Faff & R.D. Brooks, 1998. "Time-varying Beta Risk for Australian Industry Portfolios: An Exploratory Analysis," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 25(5&6), pages 721-745.
  17. Boldin Michael D., 1996. "A Check on the Robustness of Hamilton's Markov Switching Model Approach to the Economic Analysis of the Business Cycle," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 1(1), pages 1-14, April.
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