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Regime switching in volatilities and correlation between stock and bond markets

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This paper studies the correlation and volatilities of the bond and stock markets in a regime- switching bivariate GARCH model. We extend the univariate Markov-Switching GARCH of Haas, Mittnik and Paolella (2004) into a bivariate Markov-switching GARCH model with Conditional Constant Correlation (CCC) speciā€¦cation within each regime, though the correlation may change across regimes. Our model allows separate state variable governing each of the three processes: bond volatility, stock volatility and bond-stock correlation. We find that a separate state variable for the correlation is needed while the two volatility processes could largely share a common state variable, especially for the 10-year bond paired with S&P500. The "low-to-high" switching in stock volatility is more likely to be associated with the "high-to-low" switching in correlation while the "low-to-high" switching in bond volatility is likely to be associated with the "low-to-high" switching in correlation. The bond-stock correlation is significantly lower when the stock market volatility is in the high regime, but higher when the bond volatility is in its high regime.

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en

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application/pdf

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http://eprints.lse.ac.uk/29306/1/Regime_Switching_in_Volatilities.pdf

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