Term structure of risk factor premiums: evidence from international equity markets

Abstract

Subject. Factor models are among the most popular tools for the analysis of stock market risks. For a long time, factor models were developed mainly by the formation of additional risk factors. However, static linear specifications are usually not sufficiently sensitive to structural changes in the market and to changes in the operational regimes of markets and in this regard they have a limited number of functions. The idea of regime switching is natural for markets and is intuitively comprehensible, therefore, in order to take into account the non-linear dependencies in factor models of risk analysis, it is advisable to use the mechanism of Markov regime switching with them. Objectives. Statistical analysis of the dynamic properties of the factor structure of risk premiums for transactions with stock market financial instruments based on a modification of the Fama & MacBeth procedure that takes into account the current market regime. Methods: In our study, we used parametric methods of data analysis and machine learning methods, description, analysis, synthesis, induction, deduction, comparison, and grouping method. An EM algorithm was used for the parametric identification of models with Markov regime switching. Results: The paper provides convincing evidence that the relationship between the excess return of financial instruments and factor loads is influenced by the current regime in the market. The main feature of the low volatility regime is the presence of a positive statistically significant risk-adjusted premium. The change in the current regime in the market is accompanied by the transformation of the factor structure of the risk premium. This fact indicates that it is reasonable to divide risk factors into speculative and protective risk factors. Speculative factors include market risks, the risk related to the size of the issuing company, and the momentum effect risk. They have a positive and significant premium in the low volatility regime. The protective factors include risk factors related to value, capital investment, and return on equity. The protective factors are characterised by a positive and significant premium only during periods of high volatility.