Regime-switching model

Since the financial crisis of 2007/8, it has become conventional to argue that market returns are often not normally distributed; that even at the best of times markets have ‘fat tails’; and that the efficient market hypothesis is arguable at best.

The academic literature has developed an approach, known as the regime-switching model, which differs from the traditional approach of assuming normal distributions in every case by allowing the existence of two very different regimes: a normal one and a crisis one, distinct in terms of lower and higher volatility respectively, and consequently with differing expected returns. RiskMetrics, MSCI Barra and Goldman Sachs have all developed dual models of this kind. The crisis model is built using data collected from past crisis periods, on the assumption that ‘crisis’ markets have common characteristics that can be modelled.

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