Association between Markov regime-switching market volatility and beta risk: Evidence from Dow Jones industrial securities.

In this paper, the volatility of the return generating process of the market portfolio and the slope coefficient of the market model is assumed to follow a Markov switching process of order one. The results indicate very strong evidence of volatility switching behaviour in a sample of returns in the S&P500 index. In three of the thirty securities in the Dow Jones index, the estimated slope in the market model show strong switching behaviour. In these three securities the low risk state is more persistent than the high-risk state. For each security we estimate the conditional probabilities that the security is in the high (low) risk state given the market is in the high (low) volatility regime and show that this information can be used to classify securities into three distinct groups. There is no association between these groups and the securities' constant beta estimated in the market model and the Sharpe index. Some directions for further research are discussed.