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

TL;DR

This paper introduces a novel semi-parametric approach combining regime-switching models with local Gaussian correlation to analyze asymmetric, time-varying dependencies in financial markets, revealing regime-specific dependence structures and tail behaviors.

Contribution

It proposes a new LGC-based bootstrap test for equality of dependence structures across regimes, offering an intuitive and flexible alternative to copula-based methods.

Findings

Dependence structures differ significantly across regimes.

Lower tail dependence is prominent during financial downturns.

Dependence becomes less symmetric and weaker during crises.

Abstract

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.