Regime switching in the relationship between equity returns and short-term interest rates in the UK

Abstract

We examine the relationship between short term interest rates and UK equity returns using a two regime Markov Switching EGARCH model. We find one high-return, low variance regime in which the conditional variance of equity returns responds persistently but symmetrically to equity return innovations. In the other, low-mean, highvariance, regime there is evidence that equity volatility responds asymmetrically and without persistence to shocks to equity returns. There is evidence of a regime dependent relationship between shorter maturity interest rate differentials and equity return volatility. Furthermore, there is evidence that events in the money markets influence the probability of transition across regimes.

Asymmetric Reactions of China’s Stock Market to Short-Term Interest Rates

“…Chen (2007) and Henry (2009) chose to have no AR lag in stock returns. We follow their methodology to choose no AR lag in R t based on the calculation of the Akaike information criterion (AIC).…”

“…All the above findings are based on the GJR-GARCH model which we use because Engle and Ng (1993) indicates the GJR-GARCH is a better model to measuring the impacts of news on volatility. However, the classical model to test the impacts of short term interest rate on stock market is the EGARCH model proved by Henry (2009 …”

Testing for “Contagion” of the Subprime Crisis on the Middle East and North African Stock Markets: A Markov Switching EGARCH Approach

“…According to Chen (2009Chen ( , 2010 and Henry (2009), this two regime switching model allows us to identify both bull and bear stock markets. The bull market is characterized by a high-mean, low-variance regime and it corresponds to the no-crisis period while the bear market is characterized by a low-mean, high-variance regime and it corresponds to the crisis period.…”

“…On the one hand, we extend the Cerra and Saxena (2002) methodology using a two regime Markov-Switching Exponential GARCH model introduced by Henry (2009) which captures persistence in the conditional variance and asymmetry in stock volatility 4 within each regime rather than the simple Markov-Switching model. On the other hand, our paper complements the study of Lagoarde-Segot and Lucey (2009) in which the shift contagion in the MENA stock markets has been examined using the correlation approach.…”

“…To the best of the authors' knowledge, Cerra and Saxena (2002) are the only exceptions. In this study, we extend the Cerra and Saxena methodology using the MS-EGARCH(1,1) model introduced by Henry (2009). He modifies the EGARCH specification 19 to account for such structural changes in the mean and variance terms using unobserved states .…”