Can VAR Models Capture Regime Shifts in Asset Returns? A Long-Horizon Strategic Asset Allocation Perspective

Federal Reserve Bank of St. Louis Working Paper No. 2010-002B

68 Pages Posted: 9 Jan 2010 Last revised: 1 Sep 2010

See all articles by Massimo Guidolin

Massimo Guidolin

Bocconi University, Dept. of Finance; Bocconi University - CAREFIN - Centre for Applied Research in Finance

Stuart Hyde

Alliance Manchester Business School - University of Manchester

Multiple version iconThere are 2 versions of this paper

Date Written: August 24, 2010

Abstract

We examine whether simple VARs can produce empirical portfolio rules similar to those obtained under a range of multivariate Markov switching models, by studying the effects of expanding both the order of the VAR and the number/selection of predictor variables included. In a typical stock bond strategic asset allocation problem on US data, we compute the out-of-sample certainty equivalent returns for a wide range of VARs and compare these measures of performance with those typical of non linear models that account for bull-bear dynamics and characterize the differences in the implied hedging demands for a long-horizon investor with constant relative risk aversion preferences. In a horse race in which models are not considered in their individuality but instead as an overall class, we find that a power utility investor with a constant coefficient of relative risk aversion of 5 and a 5-year horizon, would be ready to pay as much as 8.1% in real terms to be allowed to select models from the MS class, while analogous calculation for the whole class of expanding window VAR leads to a disappointing 0.3% per annum. We conclude that most (if not all) VARs cannot produce portfolio rules, hedging demands, or out-of-sample performances that approximate those obtained from equally simple non-linear frameworks.

Keywords: Predictability, Strategic Asset Allocation, Markov Switching, Vector Autoregressive Models, Out-of-Sample Performance

JEL Classification: G11, C53

Suggested Citation

Guidolin, Massimo and Hyde, Stuart, Can VAR Models Capture Regime Shifts in Asset Returns? A Long-Horizon Strategic Asset Allocation Perspective (August 24, 2010). Federal Reserve Bank of St. Louis Working Paper No. 2010-002B, Available at SSRN: https://ssrn.com/abstract=1533525 or http://dx.doi.org/10.2139/ssrn.1533525

Massimo Guidolin (Contact Author)

Bocconi University, Dept. of Finance ( email )

Via Roentgen, 1
2nd floor
Milan, MI 20136
Italy

Bocconi University - CAREFIN - Centre for Applied Research in Finance

Via Sarfatti 25
Milan, 20136
Italy

Stuart Hyde

Alliance Manchester Business School - University of Manchester ( email )

Booth Street West
Mezzanine Floor, Crawford House
Manchester M15 6PB
United Kingdom
44 (0) 161 275 4017 (Phone)
44 (0) 161 275 4023 (Fax)

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
264
Abstract Views
1,451
Rank
109,843
PlumX Metrics