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Are the dynamic linkages between the macroeconomy and asset prices time-varying?

  • Massimo Guidolin
  • Sadayuki Ono

We estimate a number of multivariate regime switching VAR models on a long monthly data set for eight variables that include excess stock and bond returns, the real T-bill yield, predictors used in the finance literature (default spread and the dividend yield), and three macroeconomic variables (inflation, real industrial production growth, and a measure of real money growth). Heteroskedasticity may be accounted for by making the covariance matrix a function of the regime. We find evidence of four regimes and of time-varying covariances. We provide evidence that the best in-sample fit is provided by a four state model in which the VAR(1) component fails to be regime-dependent. We interpret this as evidence that the dynamic linkages between financial markets and the macroeconomy have been stable over time. We show that the four-state model can be helpful in forecasting applications and to provide one-step ahead predicted Sharpe ratios.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2005-056.

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Date of creation: 2005
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Handle: RePEc:fip:fedlwp:2005-056
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