Modeling regime transition in stock index futures markets and forecasting implications

Using a time-varying regime-switching vector error correction approach, this paper seeks to address which factors explain the transition across regimes of the US and the UK stock index futures markets. The findings suggest that the basis exercises a significant effect in regime transition. The basis effect is driven by a dividend yield effect in the UK, and by a dividend yield effect and an interest rate effect in the USA. The volatility of the underlying index is another significant factor, which is consistent with the significance of the basis in conjunction with Chen <TOGGLE>et al.</TOGGLE> (1995). Furthermore, there is evidence of an international regime transition effect from the UK to the USA. In most cases, forecasts based on time-varying regime transition models are more accurate than forecasts based on models with constant transition probabilities. Copyright © 2008 John Wiley & Sons, Ltd.