Regime Changes in Stock Returns

This paper discriminates between three potential sources of instability in parameter estimates of stock return models. First, mean expected returns may vary with time. Second, return volatility may change. Third, observed returns may be affected by institutional factors as the trading mechanism evolves. To study this, we model stock returns as a stochastic function of a constant expected return and the financing costs resulting from an institutional feature, delayed delivery. We then use Goldfeld and Quandt's (1976) D-method of switching regression, deterministic switching based on time, to study the structural change in our model. We examine two eight-year sample periods and find that both contain a regime shift driven by an abrupt change in volatility. In addition, the switches occur during critical events affecting the economic environment: the first switch occurs during the turmoil of an international monetary crisis amid important Watergate developments, and the second is on the first trading day after the reappointment of Paul Volcker as chairman of the Federal Reserve Board. Although parameters estimating the impact of time-varying expected returns and the delivery system are in some cases qualitatively different between the regimes, the differences are not statistically significant and do not produce changes in our model of stock returns.