Value at Risk and Expected Shortfall Under Regime Switching
44 Pages Posted: 23 Jun 2004
Date Written: March 2004
Abstract
This paper models the joint distribution of stock and bond returns as a multivarate Markov switching process. We found evidence that four states are needed to capture the joint distribution of returns on these asset classes. This gives rise to rich patterns in the term structure of risk measures such as the Value at Risk and expected shortfall as a function of the state probabilities and investment horizon. Compared to a Gaussian IID and a multivariate GARCH specification, in general the regime switching model suggests higher tail losses and expected shortfall. We also study real-time measures of risk and out-of-sample forecasts generated by the proposed econometric specification.
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