A model for regime switching behavior in the joint distribution of stock and bond returns

The paper demonstrates the application of a Markov Switching Copula model on stock-bond relationships. This method is sufficiently flexible as it allows dependency to be modeled separately in two regimes, representing alternate bear and bull market climates. Each regime is described by a copula with asymmetric marginal density functions, allowing the so described Flight to Quality, a curious negative dependence in a bear market climate, to be described separately from the overall positive dependence in bull market climate. The optimization procedure combines Markov switching and copula theory to produce a well fitted description of the dependence structure between national stock and government bond indices. The model successfully identifies flight to quality movement and permanent shifts in market behavior.