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Regime Changes and Financial Markets

  • Andrew Ang

    ()

    (Finance and Economics Department, Business School, Columbia University, New York, NY 10027
    National Bureau of Economic Research, Cambridge, Massachusetts 02138)

  • Allan Timmermann

    ()

    (Rady School of Management and Department of Economics, University of California, San Diego, La Jolla, California 92093)

Regime-switching models can match the tendency of financial markets to often change their behavior abruptly and the phenomenon that the new behavior of financial variables often persists for several periods after such a change. Although the regimes captured by regime-switching models are identified by an econometric procedure, they often correspond to different periods in regulation, policy, and other secular changes. In empirical estimates, the means, volatilities, autocorrelations, and cross-covariances of asset returns often differ across regimes in a manner that allows regime-switching models to capture the stylized behavior of many financial series including fat tails, heteroskedasticity, skewness, and time-varying correlations. In equilibrium models, regimes in fundamental processes, such as consumption or dividend growth, strongly affect the dynamic properties of equilibrium asset prices and can induce nonlinear risk-return trade-offs. Regime switches also lead to potentially large consequences for investors' optimal portfolio choice.

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Article provided by Annual Reviews in its journal Annual Review of Financial Economics.

Volume (Year): 4 (2012)
Issue (Month): 1 ()
Pages: 313-337

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