A convex combination approach for Markov switching CAPM of interval data

Abstract

In this paper, the interval approach for Markov switching capital asset pricing model (MS-CAPM) is proposed to quantify the beta risk in two different regimes, namely a bull and a bear regimes. Instead of fitting a MS-CAPM on specific fixed reference points, such as midpoints (center method), and lower and upper bounds (MinMax method), this study suggests choosing the reference points that better represent the intervals of excess stock return and excess market return. Therefore, the convex combination (CC) method is introduced to fit the interval MS-CAPM. The proposed interval MS-CAPM performance based on the CC method is assessed and compared with the center method and the MinMax method through a simulation study and two application studies.