A Regime Switching Explanation of the Reactions of Market Participant during the Crisis

Abstract

Abstract. Empirical evidence suggest that markets are too volatile to be efficient, essentially this means the influencing factor in the pricing of assets is the reaction of market participants to the information or events, rather than the actual information. Hence in order to understand the pricing of assets, there is a need to include the behavioural finance theory. An influencing observation during the recent financial and sovereign debt crises as well as the pre-crisis period is that market participants seem to be reacting to the general financial environment. We use the SWARCH model of Cai (1994) to analyse the reaction of market participants in six key sovereign debt markets (i.e. US, German, Greek, Italian, Spanish and Portuguese) in a fast changing and highly volatile environment. In general, the evidence seems to be pointing at a change in the reaction of the market participants reflecting the underlying fast changing and highly volatile environment. Keywords. Overreaction/Underreaction Hypothesis, Regime Switching, SWARCH, Sovereign Debt Market, Crises. JEL. C13, C58, D53, D81, G01, G02, G15, H63.