A regime switching model with exogenous variables in a study of hedge funds

This paper aims to investigate the correlation between states of the global economy, and returns of hedge fund indices while assessing exposure to macroeconomic risk factors. States of the economy are assumed to follow a three-state Markov chain, and are estimated using the MSCI World Index; estimated states appear to capture most significant global events. State-dependent exposure to macroeconomic and financial factors is assessed with a multivariate regime-switching model which, is then extended to a multivariate quadratic one. It is concluded that the exposure to any given factor is largely state dependent: different hedge fund indices exhibit exposure to different factors conditional upon the state of the global economy, the ensuing changes in economic indicators, and the changes in capital flows. Furthermore, macroeconomic factors are found to be significant in estimating the returns of hedge fund indices, and quadratic models using both financial and economic factors yield significantly better estimates.