Application of regime-switching and structural break models in financial economics

Chengping Zhang

doi:10.7273/000006017

This dissertation consists of two manuscripts. In the first manuscript, we use multivariate regime-switching models to investigate the portfolio performance benefits associated with the addition of emerging market and developed market mutual funds to a global investor. Our approach admits time-varying risk and returns in a regime-switching model with both global equity market and foreign exchange risk factors. Conditional performance, as measured by a state dependent Jensen s alpha, varies by economic regimes. Emerging market mutual funds provide strongly positive and significant state dependent alphas when the idiosyncratic volatility of emerging markets is small. Ignoring the existence of regimes could potentially misspecify mutual fund performance in some economic states, if a regime-switching model characterizes the economic context. We also find that foreign exchange risk is not only priced, but priced differently across economic regimes. Our findings are robust to fixed or time-varying transition probability models, and to our use of either a one-factor market risk model, or a two-factor model with both market and foreign exchange risk factors. In the second manuscript, we find that global equity markets exhibit two structural changes over the previous two decades using a multivariate structural break model. The estimated structural breaks are comparable across multiple models. We find that emerging markets provide significant alphas to a well diversified global investor in US and developed markets during the first and third periods typically, pre-1997 and post-2003 (or post-2006 in our smallest model). The performance benefit is largely due to the behavior of Latin American emerging market investments. We also present spanning tests that demonstrate that emerging markets are not spanned by the MSCI US market, MSCI non-US developed market index, and the US small, big, high value and growth portfolios. Our results are helpful in describing the variance in results across numerous studies of emerging market portfolio performance using different sample periods and countries. Our evidence suggests that emerging market equity investments, and especially Latin American investments, lead to positive Jensen s alphas and spanning rejections in the sample periods from January 1988 through March 1997, and from April 2003 through January 2010.

Application of regime-switching and structural break models in financial economics

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