Abstract
In the present paper, we test the use of Markov-Switching (MS) models with time-fixed or Generalized Autoregressive Conditional Heteroskedasticity (GARCH) variances. This, to enhance the performance of a U.S. dollar-based portfolio that invest in the S&P 500 (SP500) stock index, the 3-month U.S. Treasury-bill (T-BILL) or the 1-month volatility index (VIX) futures. For the investment algorithm, we propose the use of two and three-regime, Gaussian and t-Student, MS and MS-GARCH models. This is done to forecast the probability of high volatility episodes in the SP500 and to determine the investment level in each asset. To test the algorithm, we simulated 8 portfolios that invested in these three assets, in a weekly basis from 23 December 2005 to 14 August 2020. Our results suggest that the use of MS and MS-GARCH models and VIX futures leads the simulated portfolio to outperform a buy and hold strategy in the SP500. Also, we found that this result holds only in high and extreme volatility periods. As a recommendation for practitioners, we found that our investment algorithm must be used only by institutional investors, given the impact of stock trading fees.
Highlights
Market volatility is a fundamental concept in Finance theory
By the fact that volatility index (VIX) futures could be an important diversification and risk hedging tool, we propose the use of MS models to determine the timing of VIX futures investing
These two authors model the volatility (VIX) risk premium and gave strong proofs about the limitations of VIX futures as trading tool. This is because, given the roll-over cost, there is a fast mean-reverting feature of volatility and the related risk premium is negative. This result is the main motivation of the use of MS and MS-Generalized Autoregressive Conditional Heteroskedasticity (GARCH) models for VIX future trading timing
Summary
Market volatility is a fundamental concept in Finance theory. This, by the fact that the main rationale of financial asset pricing estates that the higher the risk, the higher the reward (return or risk premia from a “risk-free” asset). VIX that measure the market volatility level, given the actual S&P 500 index put and call market version measured the observed volatility of options of the less diversified S&P 100 stock prices. These futures could be used for diversification purposes if there is an appropriate method to enhance their timing. Nowadays there is a lack of well of 22 known quantitative methods that could help investors to actively manage their VIX/equity portfolio positions
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