Between The Rock and a Hard Place: Regime Switching in the RelationshipBetween Short-Term Interest Rates and Equity Returns in the UK

Abstract

We examine the relationship between short term interest rates and UK equity returns using a two regime Markov Switching EGARCH model. We find one high-return, low variance regime in which the conditional variance of equity returns responds persistently but symmetrically to equity return innovations. In the other, low-mean, highvariance, regime there is evidence that equity volatility responds asymmetrically and without persistence to shocks to equity returns. There is evidence of a regime dependent relationship between shorter maturity interest rate differentials and equity return volatility. Furthermore, there is evidence that events in the money markets influence the probability of transition across regimesRegime switching; Time varying transition probabilities; Newsimpact surfaces; Asymmetric volatility; Interest Rate Spreads