Identifying and Explaining the Number of Regimes Driving Asset Returns

A shared belief in the financial industry is that markets are driven by two types of regimes. Bull markets would be characterized by high returns and low volatil- ity whereas bear markets would display low returns coupled with high volatility. Modelling the dynamics of different asset classes (stocks, bonds, commodities and currencies) with a Markov-Switching model and using a density-based test, we re- ject the hypothesis that two regimes are enough to capture asset returns' evolutions. Once the accuracy of our test methodology has been assessed through Monte Carlo experiments, our empirical results point out that between three and five regimes are required to capture the features of each asset's distribution. A probit multinomial regression highlights that only a part of the underlying number of regimes is par- tially explained by the absolute average yearly risk premium and by distributional charateristics of the returns such as the kurtosis.