Handbooks of Research Methods and Applications series
Edited by Adrian R. Bell, Chris Brooks and Marcel Prokopczuk
Chapter 1: Markov switching models in asset pricing research
Recent years have marked an acceleration in the number and quality of asset pricing papers that have placed regime-switching and in particular Markov switching models (henceforth, MSMs) at the heart of their framework. In this chapter I survey applications of MS modeling to financial economics, with a particular emphasis on tackling asset pricing questions and problems. As a result, I shall keep separate the task of building (equilibrium) dynamic asset pricing models in which beliefs are informed by some MSM framework from the (simpler) goal of fitting MSMs on the data and loosely using MSM implications to test one or more hypotheses of interest. One equivalent way to understand this difference is that it stems from the fact that while in simple fitting exercises, a researcher only cares for modeling (at most, predicting) the physical (conditional) density under the physical measure, P, when MSMs are used to build dynamic asset pricing models (DAPMs), then she cares for the role of regime shifts both under P as well as under the risk neutral measure, Q. A brief overview of the structure of this survey may help a reader to ease into the material covered in this chapter. Section 1.2 provides a primer to MSMs and briefly deals with their specification and estimation (see Guidolin, 2012, or Hamilton, 1994, for additional details concerning testing and prediction).
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