Risk–Return Relationship in BRIC Equity Markets: Evidence from Markov Regime Switching Model with Time-varying Transition Probabilities

Abstract

A rich literature supports the existence of both positive and negative relationship between the risk and return in the developed equity markets. However, the present study attempts to capture the risk–return relationship in the most promising and opportunities-instilled emerging market club, the “BRIC” equity markets, by employing a Markov regime switching model with time-varying transition probabilities, further taking St. Louis Fed Financial Stress Index (the US financial market stress) as an economic variable. The weekly benchmark index values are used in the analysis, spanning from the year 2004 to 2013. The results report the existence of time-varying transition probabilities with respect to the Brazilian and Indian markets only and fixed transition probabilities for the other countries undertaken. The Markov results support the existence of two regimes, wherein regime-1 reports a positive risk–return relationship, and regime-2 reports a negative relationship between the risk and return. Ironically, the Chinese equity market is found to be the riskiest but a perfect hedge instrument amongst others, considering its risk–return interactions in both the regimes. Furthermore, a lower level of financial stress in the US financial market is associated with a higher probability of remaining in the “Bullish” regime-1 in the Indian market as well as Brazilian market. Moreover, there is a positive co-movement between the US financial stress and the expected time-varying duration of remaining in the “Bearish” regime. This shows that due to the growing interdependence among the worldwide economies, a financial stress in one economy does have an impact on the other markets and risk–return relationship in their equity markets. An understanding of the risk–return dynamics coupled with the impact of exogenous variables is an imperative task that a portfolio manager must undertake so as to justify and manage the investments made in the equity markets.