Euro-Philippine Network in Banking and Finance
Markov-Switching Market Risk
Carlos BautistaDaniel Goyeau
Joel Yu
27 August 2007International Conference on the
Safety and Efficiency of the Financial Sector
Euro-Philippine Network in Banking and Finance
Background
• Market Risk is measured by Beta, cov(r i,rm)/var(rm)
• Traditional Estimation of Beta: Market ModelRi = a + beta (Rm-Rf)
• In the CAPM model, beta explains the cross section of expected returns on securities
Euro-Philippine Network in Banking and Finance
Literature
• Time-varying beta– Empirical evidence– Nature of change/causes of change
• Beta as an explanatory variable and predictor of events
• Difficulty with existing methods
Euro-Philippine Network in Banking and Finance
Model and Data
• Markov-switching market risk– Two states– Fixed transition probabilities– Markov-switching process
• Data– Datastream price data of 22 stocks of 17 firms
in the PSEi– 91-day T-bill rate
Euro-Philippine Network in Banking and Finance
Results
• There is a strong statistical support for non-linearity in the market model
• In most cases, there is a fairly high frequency of changes in the market risk of common stocks in the Philippines from low beta regime to high beta regimes.
• There are few cases where there is a transient change in market risk, albeit significantly longer in duration.
• There are cases where there seems to be a permanent change in the market risk of the firm.
Euro-Philippine Network in Banking and Finance
Results: Case 1
0.0
0.5
1.0
94 95 96 97 98 99 00 01 02 03 04 05
Jolibee Food Corp. - smoothed probability of a low beta regime
0.0
0.5
1.0
94 95 96 97 98 99 00 01 02 03 04 05
Metro Pacific - smoothed probability of a low beta regime
Jollibee Foods CorpLow Beta: 0.43High Beta: 1.19
Metro PacificLow Beta: 1.23High Beta: 2.35
Euro-Philippine Network in Banking and Finance
0.0
0.5
1.0
94 95 96 97 98 99 00 01 02 03 04 05
Meralco B - smoothed probability of a low beta regime
Results: Case 2
0.0
0.5
1.0
94 95 96 97 98 99 00 01 02 03 04 05
ICTSI - smoothed probability of a low beta regime
ICTSILow Beta: 0.80High Beta: 2.16
MERALCOLow Beta: 1.01High Beta: 2.28
Euro-Philippine Network in Banking and Finance
Results: Case 3
0.0
0.5
1.0
94 95 96 97 98 99 00 01 02 03 04 05
Bank of the Phil. Islands - smoothed probability of a low beta regime
0.0
0.5
1.0
94 95 96 97 98 99 00 01 02 03 04 05
San Miguel B - smoothed probability of a low beta regime
SAN MIGUELLow Beta: 0.54High Beta: 0.89
BPILow Beta: 0.30High Beta: 1.27
Euro-Philippine Network in Banking and Finance
Conclusions
• This study demonstrates that time variation in the CAPM can be adequately modeled through Markov switching techniques.
• Results show that the technique is a productive alternative in evaluating the market risk of firms in the Philippines.
• Shifts in the market risk seem to be related to market developments which can have a permanent or transient change in the volatilities of security returns relative to that of the market.