Estimating A Regime Switching Pairs Trading Model

We consider a discrete time pairs trading model which includes regime changes in the dynamics. The prices of the pair of assets, and so their difference or spread, depend on the state of the market, which in turn is modelled by a finite state Markov chain. Different states of the chain give rise to different parameters in the dynamics of the spread. However, the state of the chain is not observed directly but only through the prices or spread. Based on observations of the spread this paper provides recursive estimates for both the state of the market and all coefficients in the model