Search results
1 – 10 of over 2000Recently, there has been much progress in developing Markov switching stochastic volatility (MSSV) models for financial time series. Several studies consider various MSSV…
Abstract
Recently, there has been much progress in developing Markov switching stochastic volatility (MSSV) models for financial time series. Several studies consider various MSSV specifications and document superior forecasting power for volatility compared to the popular generalized autoregressive heteroscedasticity (GARCH) models. However, their application to option pricing remains limited, partially due to the lack of convenient closed-form option pricing formulas which integrate MSSV volatility estimates. We develop such a closed-form option pricing formula and the corresponding hedging strategy for a broad class of MSSV models. We then present an example of application to two of the most popular MSSV models: Markov switching multifractal (MSM) and component-driven regime switching (CDRS) models. Our results establish that these models perform well in one-day-ahead forecasts of option prices.
Details
Keywords
I review the burgeoning literature on applications of Markov regime switching models in empirical finance. In particular, distinct attention is devoted to the ability of Markov…
Abstract
I review the burgeoning literature on applications of Markov regime switching models in empirical finance. In particular, distinct attention is devoted to the ability of Markov Switching models to fit the data, filter unknown regimes and states on the basis of the data, to allow a powerful tool to test hypotheses formulated in light of financial theories, and to their forecasting performance with reference to both point and density predictions. The review covers papers concerning a multiplicity of sub-fields in financial economics, ranging from empirical analyses of stock returns, the term structure of default-free interest rates, the dynamics of exchange rates, as well as the joint process of stock and bond returns.
Details
Keywords
I survey applications of Markov switching models to the asset pricing and portfolio choice literatures. In particular, I discuss the potential that Markov switching models have to…
Abstract
I survey applications of Markov switching models to the asset pricing and portfolio choice literatures. In particular, I discuss the potential that Markov switching models have to fit financial time series and at the same time provide powerful tools to test hypotheses formulated in the light of financial theories, and to generate positive economic value, as measured by risk-adjusted performances, in dynamic asset allocation applications. The chapter also reviews the role of Markov switching dynamics in modern asset pricing models in which the no-arbitrage principle is used to characterize the properties of the fundamental pricing measure in the presence of regimes.
Details
Keywords
The unemployment rate (UR) is the leading macroeconomic indicator used in the credit card loss forecasting. COVID-19 pandemic has caused an unprecedented level of volatility in…
Abstract
Purpose
The unemployment rate (UR) is the leading macroeconomic indicator used in the credit card loss forecasting. COVID-19 pandemic has caused an unprecedented level of volatility in the labor market variables, leading to new challenges to use UR in the credit risk modeling framework. This paper examines the dynamic relationship between the credit card charge-off rate and the unemployment rate over time.
Design/methodology/approach
This study uses quarterly observations of charge-off rates on credit card loans of all commercial banks from Q1 1990 to Q4 2020. Univariate, multivariable, machine learning, and regime-switching time series modeling are employed in this research.
Findings
The authors decompose UR into two components – temporary and permanent UR. The authors find the spike in UR during COVID-19 is mainly attributed to the surge in temporary layoffs. More importantly, the authors find that the credit card charge-off rate is primarily driven by permanent UR while temporary UR has little predictive power. During recessions, permanent UR seems to be a stronger indicator than total UR. This research highlights the importance of using permanent UR for credit risk modeling.
Originality/value
The findings in the research can be applied to the credit card loss forecasting and CECL reserve models. In addition, this research also has implications for banks, macroeconomic data vendors, regulators, and policymakers.
Details
Keywords
Kai Li and Chenjie Xu
This paper aims to study the asset pricing implications for stock and bond markets in a long-run risks (LRR) model with regime shifts. This general equilibrium framework can not…
Abstract
Purpose
This paper aims to study the asset pricing implications for stock and bond markets in a long-run risks (LRR) model with regime shifts. This general equilibrium framework can not only generate sign-switching stock-bond correlations and bond risk premium, but also quantitatively reproduce various other salient empirical features in stock and bond markets, including time-varying equity and bond return premia, regime shifts in real and nominal yield curves, the violation of the expectations hypothesis of bond returns.
Design/methodology/approach
The researchers study the joint determinants of stock and bond returns in a LRR model framework with regime shifts in consumption and inflation dynamics. In particular, the means, volatilities, and the correlation structure between consumption growth and inflation are regime-dependent.
Findings
The model shows that the term structure of interest rates and stock-bond correlation are intimately related to business cycles, while LRR play a more important role in accounting for high equity premium than do business cycle risks.
Originality/value
This paper studies the joint determinants of stock and bond returns in a Bansal and Yaron (2004) type of LRR framework. This rational expectations general equilibrium framework can (1) jointly match the dynamics of consumption, inflation and cash flow; (2) generate time-varying and sign-switching stock and bond correlations, as well as generating sign-switching bond risk premium; and (3) coherently explain another long list of salient empirical features in stock and bond markets, including time-varying equity and bond return premia, regime shifts in real and nominal yield curves, the violation of the expectations hypothesis of bond returns.
Details
Keywords
We compare the finite sample power of short- and long-horizon tests in nonlinear predictive regression models of regime switching between bull and bear markets, allowing for time…
Abstract
We compare the finite sample power of short- and long-horizon tests in nonlinear predictive regression models of regime switching between bull and bear markets, allowing for time varying transition probabilities. As a point of reference, we also provide a similar comparison in a linear predictive regression model without regime switching. Overall, our results do not support the contention of higher power in longer horizon tests in either the linear or nonlinear regime switching models. Nonetheless, it is possible that other plausible nonlinear models provide stronger justification for long-horizon tests.
Details
Keywords
Massimo Guidolin and Carrie Fangzhou Na
We address an interesting case – the predictability of excess US asset returns from macroeconomic factors within a flexible regime-switching VAR framework – in which the presence…
Abstract
We address an interesting case – the predictability of excess US asset returns from macroeconomic factors within a flexible regime-switching VAR framework – in which the presence of regimes may lead to superior forecasting performance from forecast combinations. After documenting that forecast combinations provide gains in predictive accuracy and that these gains are statistically significant, we show that forecast combinations may substantially improve portfolio selection. We find that the best-performing forecast combinations are those that either avoid estimating the pooling weights or that minimize the need for estimation. In practice, we report that the best-performing combination schemes are based on the principle of relative past forecasting performance. The economic gains from combining forecasts in portfolio management applications appear to be large, stable over time, and robust to the introduction of realistic transaction costs.
Since the UK Companies Act 1981, different reporting standards have developed for different classes of company to reduce the reporting burden on non-listed companies. There are…
Abstract
Purpose
Since the UK Companies Act 1981, different reporting standards have developed for different classes of company to reduce the reporting burden on non-listed companies. There are now different regimes for listed, large private, medium-sized, small and micro companies. This strategy raises the issue of whether earnings quality across the different classes of company is comparable. The paper aims to discuss this issue.
Design/methodology/approach
The paper uses the smoothness of earnings to measure reporting quality across the different types of companies from 2006 to 2013, based on 514,000 observations. Smoothness is an indicator of poor quality.
Findings
The authors find that listed companies have the highest earnings quality, closely followed by small and micro companies. In contrast, large private and medium-sized companies have much lower earnings quality. Overall, the authors find companies which switch between reporting regimes have lower earnings quality. The authors also find that earnings quality is not affected by the small company exemption from audit.
Research limitations/implications
Companies filing abbreviated accounts are excluded since they do not file an income statement. The recent revisions to UK GAAP (FRS 102 and FRS 105) are not examined due to insufficient data.
Practical implications
The Financial Reporting Council’s (FRC) strategy of reducing the financial reporting and auditing obligations for small companies seems not to have significantly affected earnings quality. However, the FRC may need to review the reporting requirements of large private and medium-sized companies and also the option of companies to switch between reporting regimes; in these settings earnings quality appears to be weaker.
Originality/value
The paper studies the effect of earnings quality across the different reporting regimes in the UK. Novel and important features of the study are that the sample covers a wide variety of small and micro companies which have not been analyzed previously; the results are disaggregated by year, for assurance that the results are not driven by a single rogue year; and the authors also address the small company exemption from audit, and the flexibility of non-listed companies to switch between regimes.
Details