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Estimation of Markov regime-switching regression models with endogenous switching

  • Kim, Chang-Jin
  • Piger, Jeremy
  • Startz, Richard

Following Hamilton [1989. A new approach to the economic analysis of nonstationary time series and the business cycle. Econometrica 57, 357-384], estimation of Markov regime-switching regressions typically relies on the assumption that the latent state variable controlling regime change is exogenous. We relax this assumption and develop a parsimonious model of endogenous Markov regime-switching. Inference via maximum likelihood estimation is possible with relatively minor modifications to existing recursive filters. The model nests the exogenous switching model, yielding straightforward tests for endogeneity. In Monte Carlo experiments, maximum likelihood estimates of the endogenous switching model parameters were quite accurate, even in the presence of certain model misspecifications. As an application, we extend the volatility feedback model of equity returns given in Turner et al. [1989. A Markov model of heteroskedasticity, risk, and learning in the stock market. Journal of Financial Economics 25, 3-22] to allow for endogenous switching.

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Article provided by Elsevier in its journal Journal of Econometrics.

Volume (Year): 143 (2008)
Issue (Month): 2 (April)
Pages: 263-273

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Handle: RePEc:eee:econom:v:143:y:2008:i:2:p:263-273
Contact details of provider: Web page: http://www.elsevier.com/locate/jeconom

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  1. James D. Hamilton & Daniel F. Waggoner & Tao Zha, 2007. "Normalization in Econometrics," Econometric Reviews, Taylor & Francis Journals, vol. 26(2-4), pages 221-252.
  2. Christopher A. Sims & Tao Zha, 2004. "Were there regime switches in U.S. monetary policy?," FRB Atlanta Working Paper 2004-14, Federal Reserve Bank of Atlanta.
  3. Campbell, John Y. & Hentschel, Ludger, 1992. "No news is good news *1: An asymmetric model of changing volatility in stock returns," Journal of Financial Economics, Elsevier, vol. 31(3), pages 281-318, June.
  4. Brandt, Michael W. & Kang, Qiang, 2004. "On the relationship between the conditional mean and volatility of stock returns: A latent VAR approach," Journal of Financial Economics, Elsevier, vol. 72(2), pages 217-257, May.
  5. Barry Arnold & Robert Beaver & A. Azzalini & N. Balakrishnan & A. Bhaumik & D. Dey & C. Cuadras & J. Sarabia & Barry Arnold & Robert Beaver, 2002. "Skewed multivariate models related to hidden truncation and/or selective reporting," TEST: An Official Journal of the Spanish Society of Statistics and Operations Research, Springer;Sociedad de Estadística e Investigación Operativa, vol. 11(1), pages 7-54, June.
  6. Christopher A. Sims & Tao Zha, 2002. "Macroeconomic switching," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  7. Turner, Christopher M. & Startz, Richard & Nelson, Charles R., 1989. "A Markov model of heteroskedasticity, risk, and learning in the stock market," Journal of Financial Economics, Elsevier, vol. 25(1), pages 3-22, November.
  8. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
  9. French, Kenneth R. & Schwert, G. William & Stambaugh, Robert F., 1987. "Expected stock returns and volatility," Journal of Financial Economics, Elsevier, vol. 19(1), pages 3-29, September.
  10. Filardo, Andrew J, 1994. "Business-Cycle Phases and Their Transitional Dynamics," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(3), pages 299-308, July.
  11. Bekaert, Geert & Wu, Guojun, 2000. "Asymmetric Volatility and Risk in Equity Markets," Review of Financial Studies, Society for Financial Studies, vol. 13(1), pages 1-42.
  12. Goldfeld, Stephen M. & Quandt, Richard E., 1973. "A Markov model for switching regressions," Journal of Econometrics, Elsevier, vol. 1(1), pages 3-15, March.
  13. Kim, Chang-Jin & Morley, James C & Nelson, Charles R, 2004. "Is There a Positive Relationship between Stock Market Volatility and the Equity Premium?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(3), pages 339-60, June.
  14. Francis X. Diebold & Joon-Haeng Lee & Gretchen C. Weinbach, 1993. "Regime switching with time-varying transition probabilities," Working Papers 93-12, Federal Reserve Bank of Philadelphia.
  15. Turner, C.M. & Startz, R. & Nelson, C.R., 1989. "The Markov Model Of Heteroskedasticity, Risk And Learning In The Stock Market," Working Papers 89-01, University of Washington, Department of Economics.
  16. Kazumitsu Nawata & Michael McAleer, 2001. "Size Characteristics Of Tests For Sample Selection Bias: A Monte Carlo Comparison And Empirical Example," Econometric Reviews, Taylor & Francis Journals, vol. 20(1), pages 105-112.
  17. Michael T. Owyang, 2002. "Modeling Volcker as a non-absorbing state: agnostic identification of a Markov-switching VAR," Working Papers 2002-018, Federal Reserve Bank of St. Louis.
  18. Hamilton, James D., 1990. "Analysis of time series subject to changes in regime," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 39-70.
  19. Wu, De-Min, 1973. "Alternative Tests of Independence Between Stochastic Regressors and Disturbances," Econometrica, Econometric Society, vol. 41(4), pages 733-50, July.
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