Testing for asymmetric dependency structures in financial markets: regime-switching and local Gaussian correlation

by   Kristian Gundersen, et al.

This paper examines asymmetric and time-varying dependency structures between financial returns, using a novel approach consisting of a combination of regime-switching models and the local Gaussian correlation (LGC). We propose an LGC-based bootstrap test for whether the dependence structure in financial returns across different regimes is equal. We examine this test in a Monte Carlo study, where it shows good level and power properties. We argue that this approach is more intuitive than competing approaches, typically combining regime-switching models with copula theory. Furthermore, the LGC is a semi-parametric approach, hence avoids any parametric specification of the dependence structure. We illustrate our approach using returns from the US-UK stock markets and the US stock and government bond markets. Using a two-regime model for the US-UK stock returns, the test rejects equality of the dependence structure in the two regimes. Furthermore, we find evidence of lower tail dependence in the regime associated with financial downturns in the LGC structure. For a three-regime model fitted to US stock and bond returns, the test rejects equality of the dependence structures between all regime pairs. Furthermore, we find that the LGC has a primarily positive relationship in the time period 1980-2000, mostly a negative relationship from 2000 and onwards. In addition, the regime associated with bear markets indicates less, but asymmetric dependence, clearly documenting the loss of diversification benefits in times of crisis.


page 11

page 12

page 13

page 14

page 15

page 16

page 18


Portfolio Allocation under Asymmetric Dependence in Asset Returns using Local Gaussian Correlations

It is well known that there are asymmetric dependence structures between...

Predicting Risk-adjusted Returns using an Asset Independent Regime-switching Model

Financial markets tend to switch between various market regimes over tim...

Asymptotic dependence modelling of the BRICS stock markets

With the use of empirical data, this paper focuses on solving financial ...

On the dependence structure of the trade/no trade sequence of illiquid assets

In this paper, we propose to consider the dependence structure of the tr...

Efficiency of the financial markets during the COVID-19 crisis: time-varying parameters of fractional stable dynamics

This paper investigates the impact of COVID-19 on financial markets. It ...

Portmanteau test for the asymmetric power GARCH model when the power is unknown

It is now widely accepted that, to model the dynamics of daily financial...

Construction of Minimum Spanning Trees from Financial Returns using Rank Correlation

The construction of minimum spanning trees (MSTs) from correlation matri...

Please sign up or login with your details

Forgot password? Click here to reset