Stock market volatility and equity returns: Evidence from a two-state Markov-switching model with regressors

Article history: Received 23 August 2011 Received in revised form 16 April 2012 Accepted 19 April 2012 Available online 5 May 2012 This paper proposes a two-state Markov-switching model for stock market returns in which the state-dependent expected returns, their variance and associated regime-switching dynamics are allowed to respond to market information. More specifically, we apply this model to examine the explanatory and predictive power of price range and trading volume for return volatility. Our findings indicate that a negative relation between equity market returns and volatility prevails even after having controlled for the time-varying determinants of conditional volatility within each regime. We also find an asymmetry in the effect of price range on intraand inter-regime return volatility. While price range has a stronger effect in the high volatility state, it appears to significantly affect only the transition probabilities when the stock market is in the low volatility state but not in the high volatility state. Finally, we provide evidence consistent with the ‘rebound’ model of asset returns proposed by Samuelson (1991), suggesting that long-horizon investors are expected to invest more in risky assets than shorthorizon investors. © 2012 Elsevier B.V. All rights reserved. JEL classification: C22 G12