A Multifactor Model of Stock Returns with Endogenous Regime Switching

This paper studies multifactor asset pricing in the presence of Markov regime switches. We present a state-dependent version of the Fama and French (1993) model. Performance of the unconditional Fama-French model is quite poor in some subperiods, in particular in recent years. The regime-switching model seems to overcome most of these shortcomings. We find strong evidence that two separate regimes coexist, one of which is characterized by a very high factor loading on the value risk factor. Comparison of the dynamics of the transition probabilities with major macroeconomic indicators suggest the interpretation of this state as a financial-distress regime, therefore giving support to the risk-based explanation of the size and value anomalies. In a forthcoming paper we will present evidence for the Swiss equity market as well as applications of the model to asset allocation