State-dependent size and value premium: evidence from a regime-switching asset pricing model

Abstract

The conditional CAPM suggests that the market beta and market risk premium should vary over time. In this paper, we provide evidence that the size and value premiums are also state dependent. We develop a joint Markov regime-switching model for the CAPM and the VIX index to study the regime variation of CAPM parameters and to investigate the regime-dependent size and value anomalies. Stock returns from a two-state regime-switching model exhibit the pattern of amplified size (or value) premium in the low VIX state and reversed premium in the high VIX state. A three-state regime-switching model further confirms that the value premiums might be driven by extreme market conditions. These findings have important implications for market timing and portfolio selection decisions.