Working Papers,
Copenhagen Business School, Department of Economics

Abstract: We estimate a well-specified two-state regime-switching model for Danish stock returns. The

model identifies two regimes which have low return-low volatility and high return-high

volatility, respectively. The low return-low volatility regime dominated, except in a few, short

episodes, until the beginning of the 70s whereas the 80s and 90s have been characterized by

high return and high volatility. We propose an alternative test of mean reversion which allows

for multiple regimes with potentially different constant and autoregressive terms and different

volatility. Using this test procedure we find mean reversion at 10% but not at 5% significance

level which is weaker evidence than produced by estimating a standard autoregressive model

for returns. Furthermore, when analyzing contributions of the two regimes we find that the

indication of mean reversion is due to the recent high return-high volatility regime only.

Keywords: Regime-Switching; Stock returns; Mean reversion; Denmark

JEL-codes: G19

31 pages, July 12, 2001

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