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Market regime detection via realized covariances

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  • Bucci, Andrea
  • Ciciretti, Vito
Abstract
Identifying market regimes is crucial for asset pricing and portfolio management. Within efficient markets, the macroeconomic conditions drive the demand for risky assets. Consequently, the transitions between different regimes are reflected into covariance matrices, whose time-varying coefficients react to unexpected news. Accordingly, we identify market regimes by feeding latent information embedded in the covariances to various regime-switching models and an unsupervised learning methodology. The advantage over existing methods is that our approach considers all information in the covariances to detect regimes while allowing for smooth and abrupt regime changes. We display each model's ability to correctly detect regimes through a simulation study and by evaluating a regime-switching investment strategy. Our results point to hierarchical clustering as the best-performing model for labelling market regimes with both simulated and observed data. Furthermore, we find that regime-switching models based on an observable transition variable perform well during overall periods of stress.

Suggested Citation

  • Bucci, Andrea & Ciciretti, Vito, 2022. "Market regime detection via realized covariances," Economic Modelling, Elsevier, vol. 111(C).
    • Handle: RePEc:eee:ecmode:v:111:y:2022:i:c:s0264999322000785
    DOI: 10.1016/j.econmod.2022.105832
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    References listed on IDEAS

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    Cited by:

    1. Ciciretti, Vito & Bucci, Andrea, 2023. "Building optimal regime-switching portfolios," The North American Journal of Economics and Finance, Elsevier, vol. 64(C).

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    More about this item

    Keywords

    Regime detection; Hierarchical clustering; Realized volatility; Nonlinear models;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C24 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Truncated and Censored Models; Switching Regression Models; Threshold Regression Models
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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